The market sell-off that followed the publication of the UK government’s budget plan on Friday leaves the secular administration of Liz Truss facing a crucial verdict from traders as markets reopen this week.
The reaction to Kwasi Kwarteng’s all-out gamble on tax cuts and additional borrowing to stimulate the economy has been a fierce and damaging assessment of the UK’s outlook. Seemingly unfazed by the response, the chancellor this weekend promised even more tax cuts.
If the rout deepens as traders continue to deliver their real-time verdict this week, the sell-off could escalate from a short-term embarrassment for the government to a deeper crisis that may require a political response.
“With broad unfiscally funded spending unmatched by monetary policy to offset the inflationary impulse, the currency is likely to weaken further,” Goldman Sachs analysts, including Kamakshya Trivedi, wrote in a note on Friday. to customers.
In a sign of the historic severity of Friday’s selloff, the pound was at one point on its worst day against the dollar since the record crash following the Brexit vote in 2016. In the end, the 3.6% drop was the seventh worst. over the past 50 years. At the same time, government bond yields soared, by record highs on some maturities, as investors punished the Chancellor for his unbridled drive for growth.
If sustained, the movement in yields will significantly inflate the cost of the additional £400bn ($434bn) of borrowing that the Resolution Foundation estimates is needed over the next five years to fund the plan , adding to an already inflated interest bill thanks to heaven-high inflation and a Bank of England rate hike.
The opening of Asian currency markets on Sunday evening UK time will indicate if the worst is over. At a time when liquidity is notoriously low, small moves can quickly turn into serious crises, as the famous flash crash of the pound in late 2016 showed. The gilt market opened at 8 a.m. on Monday will also be monitored.
The reaction could have huge implications. The Telegraph reported on Saturday that Truss would face a rebellion from Tory backbenchers against his tax cuts if the pound fell 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 could add to the sense of panic.
Former BOE chief Adam Posen said on Twitter that he expects Bailey to “say publicly by the middle of the week that if the GBP goes down, rates go up.” He also raised the possibility of Treasury intervention to support the pound on Sunday ahead of the open, but others underline that Britain’s foreign exchange reserves are only a fraction of those of Japan, which pursued the same policy last week.
If the weekend break has brought some calm and the moves start to return on Monday, it will give Truss and Kwarteng time to try and get back on the agenda. It would heighten the importance of the Conservative Party conference early next month, which now risks turning from a crowning of the new government into a chance to restore already battered credibility.
But the outlook for many in the market is far from rosy. Last week’s turmoil led to other predictions, including from former US Treasury Secretary Lawrence Summers, that the pound would fall below parity with the dollar. Bloomberg’s option 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, central bank support through quantitative easing, once a savior for gilts, has now been reversed by officials seeking to contain runaway price gains.
“The gilt market is adjusting to a seismic shift in the fiscal landscape and a gigantic supply and demand outlook,” HSBC analysts wrote in a note Friday. “The return of large-scale borrowing of this nature comes at the same time as the BOE also transitions from a buyer to a seller of bonds and, more importantly, other investors are increasingly concerned about the credibility. UK budget.”
After Kwarteng’s speech on Friday, the pound fell to a 37-year low at $1.084, yields on 10-year debt rose more than 30 basis points to 3.83% and the rate on five-pound notes years jumped a record 51 basis points.
Meanwhile, traders fully priced 120 basis points of additional rate hikes from the BOE at its November 3 meeting, more than double the size of the move announced Thursday that took rates to 2 .25%. Traders are also now pricing in the possibility of an intra-meeting upside, according to Trevor Pugh, head of inter-dealer broker gilt and agency offices 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 keep calm and focus on the longer-term strategy”.
For now, market sentiment on this strategy seems weak.
“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 steer clear of the pound,” Antoine Bouvet and ING’s Chris Turner. “Given our bias for the dollar rally to also get carried away, we think the market may be undervaluing the chances of parity.”
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