The market sell-off that followed the release of the UK government’s tax plan extended into a new week, increasing pressure on the Liz Truss administration for days.
Kwasi Kwarteng’s all-out bet on tax cuts and extra borrowing to stimulate the economy sparked a fierce and damaging investor assessment on Friday that sent UK assets tumbling. Seemingly unfazed by the response, the chancellor this weekend pledged to cut taxes even further.
When markets reopened in Asia on Monday, the slump showed little sign of abating as the beleaguered pound fell to a new 37-year low against the dollar. If the rout continues to deepen as traders continue to deliver their verdict in real time this week, the sell-off risks moving beyond a short-term embarrassment for the government to a deeper crisis that could require a quick political response.
With the free falling as much as 0.9% below $1.08 on Sunday night, the opening of the gold market at 8am on Monday will also be one of the highlights.
“With large unfunded spending on the fiscal side without matching monetary policy to offset inflationary momentum, the currency is likely to weaken further,” Goldman Sachs analysts including Kamakshya Trivedi wrote in a note to customers on Friday.
In a sign of the historic severity of Friday’s sell-off, the pound at one stage was set for its worst day against the dollar since the record fall that followed the Brexit vote in 2016. In the end, the 3 .6% was the seventh worst. in the last 50 years. At the same time, government bond yields soared, to a record amount at some maturities, as investors chastised the Chancellor for his lackluster growth opportunity.
If sustained, the move in yields will dramatically inflate the cost of the extra 400 billion pounds ($434 billion) of borrowing that the Resolution Foundation estimates is needed over the next five years to fund the plan, adding to an interest bill that is already skyrocketing. – high inflation and rate increase by the Bank of England.
Market moves this week can have big implications. The Telegraph reported on Saturday that Truss will face a rebellion from Tory backbenchers against his tax cuts if the pound falls to parity with the dollar. Meanwhile, some in the markets are already calling for emergency action by the BOE to stem the tide, an action unprecedented in modern times that would risk adding to the sense of panic.
Former BOE official Adam Posen said on Twitter that he expects Bailey to “say publicly by midweek that if GBP goes down, rates go up”. He also mentioned the possibility of Treasury intervention to prop up the pound on Sunday before the opening, but other pointed out that the UK’s foreign exchange reserves are a fraction of those of the likes of Japan, which followed the same policy last week.
If the weekend break has brought a bit of a lull and the moves start to pick up on Monday, that will give Truss and Kwarteng time to try and get the schedule back on track. That would increase the importance of the Tory Party Conference early next month, which now risks turning from a coronation of the new government into an opportunity to restore already battered credibility.
But the outlook for many in the market is not very optimistic. Last week’s turmoil prompted more predictions, including from former US Treasury Secretary Lawrence Summers, that the pound will fall below parity with the dollar. Bloomberg’s options pricing model now shows a one in four chance of the pound hitting $1 in the next six months, up from 14% on Thursday.
Others are expressing concerns about the future of UK debt. Worryingly, the central bank’s support through quantitative easing, once a savior for gilts, has now been reversed by officials seeking to keep a lid on runaway price gains.
“The gold market is adjusting to a seismic shift in the fiscal landscape and a mammoth outlook for supply and demand,” HSBC analysts wrote in a note on Friday. “The return of a large-scale loan of this nature comes at the same time that the BOE is also moving from a buyer to a seller of bonds and, more importantly, other investors are increasingly worried about the credibility UK taxman”.
After Kwarteng’s speech on Friday, the pound fell, 10-year bond yields rose more than 30 basis points to 3.83%, and the five-year note rate rose a record 51 basis points.
Meanwhile, traders cashed in 120 basis points of additional rate hikes from the BOE at its Nov. 3 meeting, more than double the size of the move announced Thursday that took rates to 2.25%. Traders are also now weighing the possibility of a rise within the meeting, according to Trevor Pugh, head of brokerage and agency desks at Tradition Ltd.
After the event, the new chancellor denied that investors were panicking, telling the Financial Times that “markets move all the time – it’s very important to stay calm and focus on the long-term strategy time limit”.
For now, the market outlook for this strategy looks dim.
“Unless something can be done to address these fiscal concerns, or the economy shows surprisingly strong growth data, it looks like investors will continue to avoid sterling,” ING’s Antoine Bouvet and Chris Turner wrote on Friday. “Given our bias for the dollar’s recovery to also be overdone, we believe the market may be underestimating the chances of parity.”
Sign up for the Features of Fortune email list so you don’t miss our top features, exclusive interviews and research.
