When the UK government, led by new Prime Minister Liz Truss, announced UK economy rescue plan on Friday, the reaction from investors was immediate: They hated it.
Pound fell below $1.10 mid-afternoon, hitting a 37-year low against the greenback.
British government bonds also sold off sharply. Yields on benchmark 10-year UK government bonds, which are priced at opposite prices, jumped a quarter of a percentage point – a huge move in the world of bond trading. That has pushed up borrowing costs. UK stocks, as measured by the FTSE 100
(UKX) in London, hitting its lowest level since March.
Finance Minister Kwasi Kwarteng said the government would cut personal income taxes and scrap plans to raise business taxes next spring, calling for a “new approach to a new era, focused on increasing chief”. At the same time, he pledged to push ahead with plans to subsidize energy bills for millions of homes and businesses.
But investors don’t believe the unconventional approach will really help the economy, which the Bank of England warned this week was already likely to slide into a recession. Some of them call it a big gamble.
“It is extremely unusual for a developed market currency to weaken at the same time as yields are rising strongly. But, this is exactly what has happened since [Kwarteng’s] Deutsche Bank strategist George Saravelos said in a note to clients on Friday.
One worry is that that would require a significant increase in government borrowing at a time when interest rates are rising rapidly. The Bank of England on Thursday pushed the prime rate to highest level since 2008. This is the seventh rate hike by the central bank since December.
Tax cuts, while popular politically, can also boost demand and push up prices, making the central bank’s task of controlling inflation all the more difficult.
Former US Treasury Secretary Larry Summers, speaking to Bloomberg Television, said the pound could even fall below parity against the dollar for the first time in history. (Its previous all-time low was just above $1.05 in 1985.)
“I’m sorry to say, but I think the UK is behaving a bit like an emerging market that is turning itself into a sink market,” Summers said. “Between Brexit, how the Bank of England went behind the curve and now with these fiscal policies, I think the UK will be remembered for pursuing the worst macroeconomic policies of any. any major country for a long time”.
The greenback’s dizzying rally as the Federal Reserve takes aggressive steps to curb inflation is adding to the downward pressure on the British currency.
“Unless something can be done to address these fiscal concerns, or the economy shows some surprisingly strong growth data, there’s going to be some surprisingly strong growth data,” said Antoine Bouvet and Chris Turner at ING. It looks like investors will continue to stay away from the pound.” “We think the market may undervalue the parity opportunity.”