GBP has been under selling pressure for several weeks. However, this pressure has been cranked up in the wake of the UK Government’s fiscal update (referred to as a “mini-budget”). Concerns over unfunded tax cuts have translated poorly through financial markets.
- Concerns arise over a huge debt burden and how expensive it will be to fund.
- Market implications have been to dump UK Gilts and GBP.
- Potential reactions include emergency rate hikes and currency interventions.
- The outlook for GBP remains negative, but expect huge volatility to continue.
Huge tax cuts, funded through extra debt
The UK Government has a new Prime Minister (Liz Truss) and a new Chancellor of the Exchequer (Kwasi Kwarteng). Their vision is “trickle-down economics”. In short, it involves cutting taxes for businesses and the rich in the hope of boosting investment and money in the economy. However, to fund these tax cuts, there will need to be huge amounts of extra debt for the Government.
The Resolution Foundation believe that an extra £400bn of borrowing is needed over five years to fund these growth plans. This is way beyond where markets had been expecting. There are already fears over borrowing costs as the country borrows to fund the energy crisis.
The result has been a massive sell-off on UK Gilts (government bonds). Sovereign debt has been sold off in the past six weeks across major economies. However, the rise in UK 10-year bond yields has far out-stripped the rises elsewhere. Investors are rapidly fleeing from UK investments.
The result has been a massive sell-off of the UK pound. The underperformance of GBP versus other major currencies has been dramatic since the UK’s fiscal announcement on Friday.
The dramatic fall in the pound will add to inflation pressures in the UK. According to money markets, there are another 175 basis points (+1.75%) of interest rate increases priced now for November. The current rate is 2.25%.
However, is a more immediate response required? There are a few options that the Bank of England (BoE) has open:
- Emergency rate increase. The BoE could try and get ahead of the issue and announce an emergency rate hike. The problem is that in 1992 the BoE tried unsuccessfully to defend the GBP with rate hikes and it made no difference.
- Currency intervention. Selling foreign currency holdings to buy GBP.
- Verbal intervention. Using hawkish rhetoric to try to persuade markets that the BoE is ready (similar to Draghi’s “Whatever it takes” speech).
- Holding off from quantitative tightening. The BoE said that it would be a high bar needed for amending its plans to sell bonds back into the market. This must surely be seen as a high bar and must be a bare minimum that the BoE does.
Whatever it does, with the UK Government pushing ahead with its fiscal plans (Chancellor Kwarteng doubled down on his comments over the weekend, promising to go further), it appears that the Bank of England will need to do something soon.
GBP has sold off hard. There was a flash crash early this morning, where GBP/USD fell around -400 pips in the space of 5 minutes. At that level, the price had fallen more than -1000 pips (>-10%) in the past five trading days.
However, it is interesting to see that this move has early morning flash crash has retraced. Is this the capitulation? Catching a falling knife is an extremely dangerous way to play financial markets. However, capitulation phases never tend to end quietly. There is often an aggressive spike lower followed by an often sharp recovery.
However, if we cast our minds back to COVID, there was an equally precipitous decline in GBPUSD. The price was extremely volatile for several weeks, but around the low of 1.1410, it took a few days of testing out the low before a sharp rebound kicked in.
Might it be that some sort of intervention from the BoE this time could induce another rebound? If the market is that overstretched, then a technical rally could easily set in. A rebound towards 1.1350/1.1400 would be the initial target.
For the time being though, GBP remains extremely weak and parity cannot be ruled out in the coming days.
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