SEPTEMBER 26, 2022
Tom Nicholson/Reuters. –
Global investors’ resounding rejection of the new British government’s plans for tax cuts and borrowing continued Monday, with the pound briefly falling to its weakest level against the U.S. dollar on record, leading the central bank and Treasury to speak out in an attempt to soothe markets.
Extending its losses after a historically bad day on Friday, when the tax plan was announced, the British currency plunged as low as $1.035 in the early hours of Monday morning, before recovering in the afternoon amid speculation that the Bank of England would make a statement about the currency moves, and bets that policymakers would have to raise interest rates on an emergency basis.
In the end, statements from the central bank and the government offered little relief to markets, where there are growing expectations that the pound could reach parity — a one-for-one exchange rate — with the dollar soon, a thought that was almost inconceivable a few months ago. Late on Monday, the pound resumed its decline, falling 1.8 percent to below $1.07, as well as tumbling 1 percent against the euro.
Andrew Bailey, the governor of the Bank of England, said in a statement that the bank was monitoring markets “very closely” but suggested policymakers would wait until the next scheduled meeting, on Nov. 3, to make a full assessment of the impact of the government’s policies and the decline in the pound on inflation.
The bank “will not hesitate to change interest rates by as much as needed to return inflation to the 2 percent target sustainably in the medium term, in line with its remit,” the statement said.
It wasn’t enough, said Jordan Rochester, a strategist at Nomura, who now forecasts that the pound will reach parity with the dollar by November. “So the idea of emergency rate hikes for the next month have just gone out the window,” he said.
The Bank of England would need to increase interest rates very aggressively, and the British government would need to do something to restore its fiscal credibility, just to slow down the pound’s depreciation, he added.
The pound has in part been a victim of the dollar’s strength, which is hammering currencies all over the world as the Federal Reserve raises interest rates to battle inflation in the United States. The euro fell below parity with the dollar in the summer. On Monday, China’s central bank fixed the value of the renminbi at its weakest level in more than two years, while taking steps to manage its slide.
Traders have dumped other British assets, sending the yields on government bonds to new highs, while analysts have said the government’s plan to quickly grow the economy through deregulation and tax cuts, which will require tens of billions of pounds in additional borrowing at a time of rising interest rates and high inflation, was a gamble.
The yield on benchmark 10-year bonds, which influences mortgages, business loans and other types of debt, climbed to 4.24 percent, the highest since early 2010 and nearly double the rate about a month and a half ago. The yield on two-year bonds was half a percentage point higher on Monday, at 4.57 percent, the highest since the financial crisis of 2008.
On Friday, Kwasi Kwarteng, who has been chancellor of the Exchequer for about three weeks in prime minister Liz Truss’s new government, announced a series of cuts to income taxes, reduced levies on home purchases and scrapped a plan to raise the corporate tax rate. There were dozens of other policy measures, which come on top of an expansive, costly plan to cap the cost of electricity and gas for households and businesses.
Despite the breadth of new measures, the government did not have the Office for Budget Responsibility, an independent watchdog, assess the policies and provide updated economic and fiscal forecasts.
“It was perhaps the lack of reassurances about fiscal responsibility that tipped the market over the edge,” said Jane Foley, a strategist at Rabobank.
On Sunday, government officials projected confidence in their tax-cutting agenda, despite the market’s negative reaction to the initial plans. Mr. Kwarteng said there would be “more to come” in his drive to have “people retain more of their income.”
But on Monday, as pressure on British assets grew, the Treasury said Mr. Kwarteng would set out a “medium-term fiscal plan” that would detail the government’s fiscal rules, including how debt levels are set to decline as a share of gross domestic product, in a statement on Nov. 23. The Treasury has also asked the Office for Budget Responsibility to deliver a full forecast to accompany these fiscal plans.
The government’s plans have been criticized for going too far in the opposite direction of the central bank’s goals. Policymakers at the Bank of England have been raising interest rates in an effort to bring down inflation, which is near a 40-year high. But the government’s policies could add to longer-term inflation pressures if people spend the savings on tax and energy bills and the measures don’t sufficiently grow the economy and increase investment. This has added to bets that the central bank will have to raise interest rates even higher than previously thought.
Analysts at Barclays said they expected the central bank to increase rates by three-quarters of a percentage point in November, instead of half a point, after the government surprised investors with “more tax cuts than expected and little reassurance on how the books will eventually be balanced.”
The market is facing a larger supply of British government debt, after the Bank of England last week announced a plan to start selling bonds it holds back to the market just before the government significantly increased the amount of bonds it planned to sell this year to fund its policies.
For weeks, analysts have been warning of trouble for the pound. Britain’s record-high current account deficit, which means that the value of imported goods and services exceed its exports and other income from overseas investments, makes the country reliant on the generosity of international investors. But these investors could lose confidence in Britain.
“The government does appear extremely chaotic right now,” Ms. Foley of Rabobank said. “The markets don’t believe that their policies are going to be good for the U.K. economy. Unless it can pull something out of the hat to enhance its credibility, then sterling is going to remain pretty vulnerable.”