The pound plunged to a record low on Monday, while government bonds posted heavy losses, raising expectations of an emergency hike in UK interest rates in the wake of Chancellor Kwasi Kwarteng’s package of tax cuts last week.
The currency lost a whopping 4.7 percent to trade to $1,035 early in the morning before stabilizing around $1.07 after Kwarteng vowed over the weekend to stick to its push for tax cuts, sparking warnings that the UK is in a currency crisis.
Early fall brought the pound to its lowest level ever recorded. It has heightened criticism of Friday’s tax statement, when the chancellor announced a massive new wave of loans to fund £45bn in tax cuts and a package to curb rising energy bills.
“The UK is now in the midst of a currency crisis,” said Vasileios Gkionakis, Citigroup EMEA’s head of foreign exchange strategy.
Traders pushed for an emergency rate hike to stabilize sterling ahead of the next Bank of England meeting in November. The derivatives markets are forecasting an increase of 0.75 percentage points in a week and a rise of more than 1.5 percentage points by the November meeting. Rates are expected to top 6 percent in May, up from current levels of 2.25 percent.
The central bank declined to comment on whether it is planning an emergency meeting on interest rates this week.
As a result of the major shift in interest rate expectations, UK government debt continued to fall on Monday after Friday’s heart-pounding sell-off, the worst day for the gold market since the early 1990s.
10-year gold fell in price, pushing interest rates up a sizable 0.32 percentage point to 4.12 percent, up about 3.5 percent before Friday’s fiscal announcement.
The Treasury did not comment on market movements on Monday. Kwarteng told the Financial Times in an interview last week: “I am always calm. Markets move all the time. It’s very important to stay calm and focus on the long-term strategy.”
But Mel Stride, Tory chairman of the Treasury’s selection committee, criticized the chancellor for signaling more tax cuts on Sunday.
“One thing is certain – it would be wise to take stock of how markets are weighting recent economic announcements over time rather than immediately signaling more of the same in the near term,” he said.
Meanwhile, Gerard Lyons, who advises Prime Minister Liz Truss’s new team on economic policy, said Kwarteng needs to do more to explain his approach to the markets.
“He needs to reaffirm that tax cuts are only part of the story, not the full story,” Lyons said in an interview with Bloomberg Radio. “What they’re following is a supply-side agenda.”
He said the British government should not change course and the Bank of England should raise interest rates. “We need to get rid of cheap money,” he said.
The UK does not have the resources, and probably the willingness, to try to intervene directly in the currency markets to support the pound, unlike countries like Japan, which intervened last week. However, the BoE’s monetary policy rate-setting committee has met outside the normal cycle as markets have historically been turbulent in an attempt to restore calm, usually by cutting interest rates. Since independence in 1997, the BoE has never raised rates between scheduled meetings.
Sushil Wadhwani, asset manager and former BoE policymaker, said: “If I were still with the BoE, I would be tempted to announce an additional meeting in a week.”
Westminster’s tax cuts come as the UK is already expected to spend £150bn to subsidize energy costs for consumers and businesses. A large part of these loans is financed by gilts.
Unlike major tax cuts in the 1980s, Kwarteng is borrowing tens of billions of pounds to fund its plans, adding to demand as the BoE raises rates to control inflation.
“It seems we are heading for a spiral we usually see in emerging market crises, where policymakers are struggling to restore credibility,” said Mansoor Mohi-uddin, chief economist at Bank of Singapore.
Mohi-uddin said investor confidence in sterling had been undermined by expectations that Britain’s public debt was now on an “unsustainable upward path” while the country still had a “gaping current account deficit”.
“If we continue to see these huge moves in the market, the Bank of England will have to raise interest rates, perhaps as much as 1 percentage point, to try to stabilize the pound,” he added.
The Bank of England raised interest rates by 0.5 percentage point on Thursday, following a third consecutive rate hike of 0.75 percentage point by the US Federal Reserve a day earlier.
“We had argued that sterling’s path forward would depend heavily on the near-term monetary response to inflation and well-targeted fiscal measures, but so far the realization on both fronts has been less than encouraging,” currency analysts from Goldman Sachs.
“With broad unfunded spending on the fiscal side unmatched by monetary policy to offset inflationary momentum, the currency is likely to weaken further.”
Shadow Chancellor Rachel Reeves said that Kwarteng “fueled the flames on Sunday by suggesting there may be more incentives, more unfunded tax cuts”.
Reeves, a former economist at the Bank of England, said higher interest rates worsened the cost of living for households.
“The Prime Minister and the Chancellor are like two gamblers in a casino looking for a lost streak. . . they don’t gamble with their money, they gamble all our money,” she told BBC Radio 4’s Today programme.
Labor has promised to reverse some of the tax cuts in Friday’s mini-Budget – on national insurance, corporate income tax and the abolition of the 45p rate – but would keep the looming cut in the basic income tax from 20p to 19p.
Additional reporting by Adam Samson in New York and Leo Lewis in Tokyo