EDITOR'S NOTE: If the current inflationary surge is something of a throwback to the early 1980s, what do you think about throwing in a good measure of Reaganomics? Whether you think it's a good idea, or not, it’s what UK Prime Minister Liz Truss had in mind when unveiling radical tax cuts (plus business incentives) last week at the House of Commons. The new “trickle down” approach sent the British pound plunging against the US dollar by around 3.5%. Investors were apparently spooked by the new economic plan, as UK bonds were ditched sending yields to record highs. But why such a drastic reaction? What’s keeping UK investors so skeptical of Truss’s nostalgic throwback of a vision? As you’ll see below, and as with all things, simple narratives offering simple fixes are almost always never that simple.
- Sterling dropped as low as $1.084, after a program of tax cuts was unveiled in the House of Commons.
- The pound has been on a precipitous fall against the greenback this year, hitting levels this month not seen since 1985.
- Friday’s measures were billed by the government as heralding a new era for the U.K. focused on growth, and included a mix of tax cuts and investment incentives for businesses.
Sterling had dropped as low as $1.084, extending losses it made after the measures were unveiled in the morning in London.
The pound has been on a precipitous fall against the greenback this year, hitting levels this month not seen since 1985 when it fell to $1.042.
Friday’s measures were billed by the government as heralding a new era for the U.K. focused on growth, and included a mix of tax cuts and investment incentives for businesses.
Investors also ditched U.K. bonds amid a rise in expected government debt. Paul Johnson, director of the Institute for Fiscal Studies, said markets appeared “spooked” by the scale of the “fiscal giveaway,” and said it represented the highest level of tax cuts in half a century.
Yields on 2-year U.K. government bonds hit their highest level since October 2007, and 10-year yields reached the highest level since 2010. Yields move inversely to prices.
The 10-year yield was set for its biggest daily rise since 1998, Reuters reported. At 1:45 p.m. it had risen 26 basis points to 3.759%.
U.K. equity markets also fell, with the FTSE 100 hitting its lowest level since March.
It comes after the Bank of England said Thursday that the U.K. economy was likely already in a recession as it raised interest rates by 50 basis points.
Jane Foley, senior FX strategist at Dutch bank Rabobank, said the market appeared skeptical of the government’s 2.5% growth target, though the measures were “unashamedly designed to boost demand.”
“The obvious implication is that BOE rates are likely to be higher for longer than they would have been otherwise. While textbooks suggest that higher short-term interest rates should be currency supportive, GBP has been demonstrating since the spring that this is not always the
case,” she said in a note.
With the U.K. hitting a record debt-to-GDP ratio, the pound is vulnerable to a downward revision if foreign investors are reluctant to fund the deficit, Foley said; and “markets are clearly very doubtful of the ability of this government to manage debt.”
The U.K. risks a currency crisis that could see sterling reach parity with the dollar, several analysts warned.
“We think the UK will find it increasingly difficult to finance this deficit amidst such as deteriorating economic backdrop; something has to give, and that something will eventually be a much lower exchange rate,” said Citi analyst Vasileios Gkionakis in a research note quoted by Reuters.
The euro was also down against the dollar Friday afternoon, dropping 1.5% on the day to 97 cents after a release showed the euro zone’s purchasing managers’ index fell to 48.2 in September. S&P Global said it meant the bloc was likely to enter a recession.
The dollar has been boosted this year by equity market volatility and Federal Reserve interest rate rises.
But the negative reaction to the pound was still clear, with the euro climbing 2% against sterling to 0.89.
Originally published on CNBC.