Sterling plunged to an all-time low against the US dollar in Asian trading this morning before paring some losses as confidence in the UK’s fiscal policy went up in smoke. GBPUSD slipped almost 5% to 1.035 in a brutal 20-minute selloff in the early hours, extending its run lower from Friday after the chancellor announced sweeping tax cuts.
The judgment of the market to the new fiscal policies is obvious enough; the bond vigilantes have returned with a vengeance. Following the initial sell-off we’ve seen cable bounce back to above 1.07 but it’s clear there is no love for the pound. The FTSE 100 was sharply lower on Friday amid broad based selling of stocks, but the softer pound is giving it some respite this morning as European stock markets trade generally lower.
Today looks likely to be a re-run of the day after the Brexit referendum. Sterling has crashed but the stock market looks likely to head higher, if futures markets are any guide to what’s ahead. The UK market is very international in its nature; most big companies listed in London actually earn most of their revenues and profits overseas. Those will be worth more in sterling terms as a result of the slump in the pound. So, expect shares in major stocks with big overseas earnings to lead the way.
Bond yields are rising anew, with 10-year gilt yields pushing through 3.8% this morning. German Bunds are weak too, to a lesser extent, with the equivalent Bund yield now rising up through the 1.9% level. Yields on UK long bonds had been trading well below their US equivalents, but recent weeks have seen this position decisively reverse, leaving the UK facing one of the highest levels of long-term borrowing costs amongst major nations globally.
“This budget is fiscally reckless,” said Philip Dragounis, owner of London-based wealth manager Thera Wealth Management. “It’s Trussmoronics not Trussonomics. There has been no independent assessment or costing from the Office of Budget Responsibility. If you cut taxes while at the same time spending billions on energy subsidies, and just put the bill onto government borrowing, people will not spend their extra money because they know that the bill is coming further down the line. Extra government borrowing and higher bond yields crowd out growth. Markets will lose confidence in UK assets, bond yields will continue to rise and sterling will continue to fall. Also, how will less stamp duty help first-time buyers when mortgage affordability is decreasing as interest rates go up?”
Does the Bank of England intervene?
There is already talk is of an emergency interest rate hike by the Bank to steady the ship. “Traders now price in 150bps of hikes by the BoE by November, implying an expectation it comes out with a hike before the next meeting,” said Neil Wilson, senior analyst with CFD broker Markets.com. “The central bank is in a tough place and any intervention might only be a sticking plaster as the path of least resistance for the pound is lower; parity gravity. Despite this, to not act would be wilful neglect. Just as the chancellor has taken a reckless approach to fiscal policy – a kind of economic vandalism – the BoE needs to take a very considered approach to monetary policy.”
Bank of England governor Andrew Bailey’s tenure will be remembered for this moment. Inter-meeting hikes can look like panic and Bailey is not one to react very swiftly, and direct intervention in FX markets is impossible due to lack of reserves. So, it would need to be a big hike – 100bps would be about right – but then what happens if this does nothing?
Jawboning with some hawkish rhetoric might send yields even higher and lead to further pound losses…a tough spot,” noted Wilson. “If the BoE stands idly by as the pound craters it would be as guilty as Kwarteng. But it might hope that sterling rights itself and recovers before it needs to say or do anything: the parity gravity makes this rather risky.”
Fiscal policy is adding to GBP volatility
The basic rules for any chancellor: don’t cause a panic in the markets and don’t cause a run on the pound. But policy is now adding to volatility; soaring gilt yields (higher borrowing costs) and a falling pound are the worst possible combination for the government and for the UK as a whole and yet that is exactly the macroeconomic path being pursued by the Chancellor and Prime Minister.
“It’s not like there could be any other kind of reaction when gilt issuance needs to rise drastically to fund it all as there are no spending reductions to offset the loss in tax,” said Wilson.
UK chancellor Kwasi Kwarteng is not exactly doing anything to address the market reaction. He promised “more tax cuts to come” and refused to put a limit on how much the government might borrow. On Friday he said it was a “good day” for the UK. Nineteen days in and he’s wrecked the gilt market and sent the pound on the run; not an inspiring start. The question is at what point Tory backbenchers turn on the leadership.
“I reiterate that sparking a run on the pound is the sort of thing that brings down governments – and rightly so,” said Wilson. “Does Kwarteng even understand how financial markets work? It does not appear he does.”
Of course, it’s not entirely sterling and the tax cuts – the euro is also under the cosh and slipped even further overnight as sterling fell. Overnight EURUSD dipped to 0.9550, a new 20-year low, whilst the dollar index rallied above 114 for a new two-decade high. But if we look at euro-sterling, it’s obvious the market is giving the chancellor a thumbs down. Sterling also dropped abruptly against the euro, with EURGBP hitting a two-year high this morning above 0.9250.
