When the UK government, led by new Prime Minister Liz Truss, unveiled its bailout package for the UK economy on Friday, the reaction from investors was instantaneous: they hated it.
The British pound crashed below $1.10 mid-afternoon, hitting a fresh 37-year low against the greenback.
UK government bonds also sold off strongly. The yield on the benchmark 10-year UK government bond, which moves in the opposite direction of prices, jumped a quarter of a percentage point – a very significant move in the world of bond trading. This drove 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 tax and roll back plans to raise corporate taxes next spring, calling for a “new approach for a new era, focused on the growth”. At the same time, he pledged to move forward with plans to subsidize the energy bills of millions of households and businesses.
But investors are unconvinced the unconventional approach will actually help the economy, which the Bank of England this week warned was already likely in recession. A number of them called it a huge gamble.
“It is extremely unusual for a currency in a developed market to weaken at the same time as yields rise sharply. But that’s exactly what’s happened since [Kwarteng’s] announcement,” Deutsche Bank strategist George Saravelos said in a note to clients on Friday.
One concern is that this will require a substantial increase in government borrowing at a time when interest rates are rising rapidly. The Bank of England on Thursday pushed its key rate to its highest level since 2008. It was the seventh hike in central bank interest rates since December.
Lower taxes, while politically popular, could also boost demand and drive up prices, making it even more difficult for the central bank to keep inflation under control.
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 its history. (Its previous all-time low was just above $1.05 in 1985).
“It makes me really sorry to say this, but I think the UK is behaving a bit like an emerging market turning into a submerged market,” Summers said. “Between Brexit, the Bank of England’s lag on the curve and now these fiscal policies, I think Britain will be remembered for pursuing the worst macro policies of any major country in a long time.”
The greenback’s meteoric rise as the Federal Reserve takes aggressive action to contain inflation adds downward pressure on the British currency.
“Unless something can be done to address these fiscal concerns, or the economy shows surprisingly strong growth data, it looks like investors will continue to steer clear of the pound,” said Antoine Bouvet and Chris Turner at ING in a research note. “We think the market may be underpricing the chances of parity.”