The British pound tumbled to a record low on Monday while UK government bonds extended heavy losses, stirring expectations of an emergency rise in UK interest rates in the wake of chancellor Kwasi Kwarteng’s package of tax cuts last week.
The currency lost as much as 4.7 per cent to trade as low as $1.035 early in the morning before stabilising around $1.07, after Mr Kwarteng vowed at the weekend to stick to his tax-cutting drive, prompting warnings that the UK is entering a currency crisis.
The early fall took the pound to its lowest level ever recorded. It has sharpened criticism of Friday’s fiscal statement, when the chancellor announced a massive new wave of borrowing to fund £45 billion of tax cuts and a package to curb rising energy bills.
“The UK is now in the midst of a currency crisis,” said Vasileios Gkionakis, Citigroup’s head of foreign exchange strategy.
Traders ramped up bets on an emergency interest rate rise to stabilise sterling before the Bank of England’s next meeting in November. Derivatives markets are pricing in a rise of 0.75 percentage points in a week’s time and an increase of more than 1.5 percentage points by the November meeting. Rates are expected to top 6 per cent by May, up from the current level of 2.25 per cent.
The central bank declined to comment on whether it was planning an emergency interest rate meeting this week.
Reflecting the large shift in interest rate expectations, UK government debt continued to drop on Monday following Friday’s bruising sell-off, the worst day for the gilt market since the early 1990s.
The 10-year gilt dropped in price, pushing yields up by a sizeable 0.32 percentage points to 4.12 per cent, up from about 3.5 per cent before Friday’s fiscal announcement.
The treasury did not comment on Monday on the market movements. Mr Kwarteng told the Financial Times in an interview last week: “I’m always calm. Markets move all the time. It’s very important to keep calm and focus on the longer-term strategy.”
The UK lacks the resources, and likely also the willingness, to try and intervene directly in currency markets to prop up the pound, unlike peers in Japan, which intervened last week. However, the BoE’s rate-setting monetary policy committee has met outside the normal cycle when markets have been turbulent in the past in a bid to restore calm, typically by cutting rates. Since it gained independence in 1997, the central bank has never raised rates between scheduled meetings.
Sushil Wadhwani, an asset manager and former BoE policymaker, said: “If I were still at the BoE, I would be tempted to announce an extra meeting in a week.”
Westminster’s tax cuts come as the UK is already expected to spend £150 billion to subsidise energy costs for consumers and businesses. A large portion of this borrowing is to be financed by gilts.
Unlike big tax cuts in the 1980s, Mr Kwarteng is borrowing tens of billions of pounds to fund his plans, adding to demand at a time the BoE is raising rates to bring inflation under control.
“It looks like we’re headed for a spiral that we usually see in emerging markets crises, where policymakers struggle to reassert credibility,” said Mansoor Mohi-uddin, chief economist at Bank of Singapore.
Mr Mohi-uddin said investor confidence in sterling had been undermined by expectations that UK public debt was now on an “unsustainable rising path” while the country was still running a “gaping current account deficit”.
“If we continue to see these huge moves in the market, the Bank of England will have to raise interest rates, perhaps as much as one percentage point, to try and stabilise the pound,” he added.
The Bank of England raised interest rates by 0.5 percentage points on Thursday, after a third successive 0.75 percentage point rate increase by the US Federal Reserve a day earlier.
“We had argued that the path forward for sterling would depend heavily on the monetary response to inflation over the near term and well-targeted fiscal measures, but so far the delivery has been less than encouraging on both fronts,” said foreign exchange analysts at Goldman Sachs.
“With broad unfunded spending on the fiscal side unmatched by monetary policy to offset the inflationary impulse, the currency is likely to weaken further.”
Rachel Reeves, shadow chancellor, said Mr Kwarteng had “fanned the flames on Sunday in suggesting that there may be more stimulus, more unfunded tax cuts”.
Ms Reeves, a former economist at the Bank of England, said higher interest rates were worsening the cost of living for households.
“The prime minister and chancellor are like two gamblers in a casino chasing a losing run ... they are not gambling their money, they are gambling all of our money,” she told the BBC Radio 4′s Today Programme. “I say it is irresponsible, reckless as well as being grossly unfair.”
Labour has promised to reverse some of the tax cuts in Friday’s mini-budget — on national insurance, corporation tax and the scrapping of the 45 per cent income tax rate — but would keep the looming cut in basic income tax from 20p to 19p. — Copyright The Financial Times Limited 2022
