When the UK government, led by new Prime Minister Liz Truss, unveiled its plan to rescue the British economy on Friday, the reaction from investors was instantaneous: They hated it.
The British pound crashed below $1.10 by mid-afternoon, hitting a new 37-year low against the greenback.
UK government bonds also sold off sharply. The yield on the benchmark 10-year UK government bond, which moves opposite prices, leaped by a quarter percentage point — a very large move in the world of bond trading. That pushed up borrowing costs. UK stocks, as measured by the FTSE 100 (UKX) in London, hit their lowest level since March.
Finance Minister Kwasi Kwarteng said the government would cut personal income taxes and cancel plans to raise business taxes next spring, calling for a “new approach for a new era, focused on growth.” At the same time, he pledged to press ahead with plans to subsidize the energy bills for millions of households and businesses.
But investors aren’t convinced that the unconventional approach will actually help the economy, which the Bank of England warned this week was already likely in a recession. A number of them called it a huge gamble.
“It is extremely unusual for a developed market currency to weaken at the same time as yields are rising sharply. But, this is exactly what has happened since [Kwarteng’s] announcement,” Deutsche Bank strategist George Saravelos said in a note to clients on Friday.
Heading for parity with the dollar?
One worry is that will require a substantial increase in government borrowing at a time when interest rates are rising fast. The Bank of England on Thursday pushed its key rate to its highest level since 2008. It was the central bank’s seventh interest hike since December.
Lowering taxes, while politically popular, could also boost demand and push up prices, making the central bank’s task of getting inflation under control even more difficult.
Former US Treasury Secretary Larry Summers, speaking to Bloomberg Television, said the pound could even drop below parity versus the dollar for the first time in its history. (Its previous all-time low was just above $1.05 in 1985).
“It makes me very sorry to say, but I think the UK is behaving a bit like an emerging market turning itself into a submerging market,” Summers said. “Between Brexit, how far the Bank of England got behind the curve and now these fiscal policies, I think Britain will be remembered for having pursuing the worst macroeconomic policies of any major country in a long time.”
The greenback’s breakneck rally as the Federal Reserve takes aggressive steps to rein in inflation is adding to 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, it looks like investors will continue to shun sterling,” Antoine Bouvet and Chris Turner at ING said in a research note. “We think the market may be underpricing the chances of parity.”