Sterling helped by tax cut U-turn but outlook remains challenging

Sterling rose on Monday after Britain reversed a plan to cut the highest rate of income tax.

The pound touched $1.128 after media reports of the U-turn, its highest level since September 22nd, the day before British finance minister Kwasi Kwarteng sent markets tumbling with a new “growth plan” to cut taxes and regulation, funded by vast government borrowing.

Having pared gains, sterling was later up 0.2 per cent at $1.1188.

“We get it, and we have listened,” Kwarteng said regarding the reversal of a plan to cut the 45 per cent tax band, one contentious part of the package of measures which drove sterling to an all-time low of $1.0327 and sent gilts spiralling, prompting the Bank of England to step in.

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“Clearly sterling has performed better on the news, but there are still a lot of questions, ultimately the 45 pence tax rate was only a small part of the unfunded tax cuts announced,’ Jane Foley, head of FX strategy at Rabobank, said.

“The question remains is this enough? The answer will be clear in a few weeks’ time when the Bank of England measures end. UK assets, the pound and gilts are not out of the woods yet, and the British government has a lot to do to get back credibility.”

Traders are betting it will take a bigger UK government policy U-turn to restore credibility with markets. Wagers against the currency in the next year have climbed to a record high in the options market.

The problem for investors is that the rest of the recent mini-budget, including borrowing billions to fund energy price caps and other tax cuts, is still going ahead, hurting the country’s debt sustainability.

And while the U-turn may slightly improve that outlook, it also damages the credibility of a government facing a revolt in its own party and a collapse in support in voter polls.

“The U-turn represents a concerted effort to soften the narrative regarding the UK government’s economic agenda but little to change the direction, said Neil Mehta, a portfolio manager at BlueBay Asset Management. “This dynamic should support the pound in the short-term, but we think this will be short-lived, as confidence in the government is shot and policies come home to roost over a difficult winter for the UK economy.

The late September fiscal package sent the pound to a record low a week ago and led to the biggest-ever sell-off in long maturity bonds, forcing the Bank of England to intervene to stop forced selling by pension funds to cover margin calls. There’s still uncertainty over what will happen when the Bank of England halts its bond buying on October 14th.

Wall Street banks have already predicted the pound will hit parity with the dollar this year. In the options market, traders are the most negative on the currency against the greenback over the next three months since the 2016 Brexit vote, while one-year sentiment is worse.

“Until the market sees a clear strategy to fund the energy cap freeze and other measures, we do not expect the pressure on UK gilts and sterling to ease, nor the pressure on equities, which is coming from persistent recession fears,” said Susana Cruz, a strategist at Liberum Capital.

“The chancellor is yet to reveal a clear strategy to finance its growth package (or planned expense cuts) so for now, his intent to reduce debt as a percentage of GDP does not seem plausible.” — Reuters / Bloomberg