Kwasi Kwarteng’s debt-fuelled mini-Budget sent the pound and UK bonds into meltdown on Friday – but on Monday it became clear that it was only the beginning.
Investors have dumped UK assets in the wake of the statement, selling off the pound and sending government borrowing costs surging. Britain has suddenly become a riskier bet.
In the early hours of Monday, the pound broke all records by falling to $1.0350 against the dollar, intensifying calls for an emergency Bank of England rate hike. It is understood the Bank of England is preparing to make a statement on the market turmoil as soon as today.
The fall brings the pound to its lowest level since its decimalisation in 1971, when pence and shillings were shelved.
Sterling’s descent to new lows came early in Asian trading hours, when low volumes can intensify volatility. It later recovered somewhat to $1.0732. However, the pound remains down 21pc so far this year.
The pound is also down 6.4pc against the Euro over the same period, showing the story is not just one of dollar strength.
“If the Government goes on frightening markets in the way that it has, then [the pound] is going to go on showing a vote of no confidence,” said Martin Weale, a former member of the Bank of England’s Monetary Policy Committee.
The movement in borrowing costs has been just as dramatic, with the 10-year yield on UK Government bonds rising above 4pc for the first time since 2010.
“We're seeing moves in gilts, which I've never experienced and I don’t think anyone has,” Richard McGuire, head of rates strategy for Rabobank, said. “This is the kind of movement you'd expect to see in an emerging market.”
Why were investors put off by the 'Plan for Growth'?
The key problem is credibility: investors are simply not convinced Kwarteng and Prime Minister Liz Truss can reach their target of 2.5pc annual growth.
The Government is betting that radically reducing the tax burden will help grow the size of the economy and eventually pay for itself, through higher tax receipts that can pay for the borrowing binge required.
Most economists are sceptical. Former Bank of England rate-setter Willem Buiter has branded the plans “totally, totally nuts”. Jacob Kirkegaard from the think tank Peterson Institute for International Economics meanwhile called it “the epitome of casino macroeconomics”.
Investors have also been alarmed by the lack of details in the statement. The market has been left flying blind as to how the Government will fund its planned tax cuts and what, if any, rules it will follow when addressing public finances moving forward.
The mini-Budget puts government borrowing as a share of GDP on track to hit 92.4pc in five years, Capital Economics estimates, trashing the fiscal rules put in place by the past administration that stated debt levels should come down within three years.
Details of how the tax cuts will be paid for were scant beyond borrowing and the Office for Budget Responsibility (OBR), which usually presents forecasts and costs, was not asked to look at the new policies.
“Proponents of a lower tax burden and supply side reform [are not] wrong per se,” said Simon French, chief economist at Panmure Gordon.
“The problem is this has been accompanied by an institutional ‘scorched earth’ policy of criticising the Bank of England, Treasury and side-lining the Office for Budget Responsibility.”
The Government’s plans to ramp up borrowing come at a time when rates are going up, meaning debt will not only pile up but also become more expensive to service. Many economists worry that the wide-ranging tax cuts will add too much to the national debt.
“Of course, the Government makes the point that other countries have debts of similar magnitude. But other countries are pursuing policies that seem credible,” said Weale.
"We're pursuing one that has no obvious mechanism for putting the national debt on a sustainable path.”
Excessive borrowing could also put the UK’s credit rating at risk, which would further drive up debt costs.
“This cocktail will see the UK debt to GDP ratio head steadily above 100pc and as yet we have no fiscal plan from the Chancellor as to how he plans to address this,” said Craig Inches, head of rates and cash at Royal London Asset Management.
“This will make rating agencies very nervous and it would not surprise me to see the UK placed on the naughty step.”
Lastly, investors worry that the growth plan will fuel spending at a time when near-double digit inflation is already hammering real incomes.
Lee Hardman, currency analyst at MUFG, said markets are questioning “whether such a big fiscal stimulus package is appropriate when the UK economy is close to full capacity and the measures risk reinforcing upside inflation pressures”.
The market reaction is a “clear signal” that markets have “lost confidence” in UK fiscal policy, he said.
Kwarteng’s promise for more tax cuts on Sunday suggests he will not bow to market pressure. But he has promised to set out a full fiscal plan in November, which could convince investors he is serious about keeping borrowing under control.
Still, it seems likely that something will be done in the more immediate term to stop the market panic spiralling out of control. The Chancellor’s boosting of demand through £45bn of tax cuts - with the promise of more to come - has fuelled expectations that the Bank will need to start raising interest rates even faster to tame stronger price pressures.
An emergency rate rise by the Bank of England could help prop up the pound but also risks giving a distinct whiff of panic. The Bank ruled out such an action but said it “wouldn't hesitate” to act at its next meeting.
Governor Andrew Bailey and the Bank’s rate-setters have already lifted rates to a post-financial crisis high of 2.25pc to tackle the highest inflation for 40 years.
Markets are now predicting that rates will rise between 1.50 and 1.75 percentage points by, or at, the November meeting and hit a peak of 6pc within 12 months, piling more misery on mortgage holders and the Chancellor.
This expectation has pushed the benchmark 10-year gilt yield up by a huge 0.6 percentage points to a 12-year high of 4.2pc in the two-day bond rout since Kwarteng’s mini-Budget. The 10-year yield is on course for its biggest jump in a month on record.
Gilt yields - the amount the Government pays to borrow - are reacting both to soaring interest rate expectations and fears of a flood of UK debt hitting the market as the Chancellor borrows to fund the tax cuts.
Kwarteng’s fiscal stimulus is coming at a time when the Bank of England is trying to dampen demand by tightening monetary policy, both by raising interest rates and selling the gilts it holds. It is described by economists as the equivalent of a driver putting one foot on the accelerator and the other on the brake at the same time.
What comes next for the pound and UK bonds hinges on how Kwarteng and Bailey react to the brewing crisis.
With the Chancellor defiant, it appears to be down to Bailey to tackle the crisis.
Beyond an emergency rate rise, the Bank has other options to try to calm markets. It could scrap its plan to shed £80bn of government bonds from its balance sheet in the next 12 months, including £40bn of gilt sales - something that is likely to increase yields.
Or it could use foreign currency reserves to support the pound, though analysts have raised doubts about the size of its war chest and how effective an intervention would be.
Bailey opted for a verbal intervention on Monday, promising firm action at the meeting in November. The big risk is that any intervention does little to soothe the sell-off.
“The question is, 'what is it that changes that picture?’,” says McGuire.
“A very aggressive rate hike means that the growth outlook for the UK could be much worse and the inversion of the yield curve is already pricing in a recession. We have this paradox that higher policy rates could actually be negative for sterling.”
Ex-MPC member Danny Blanchflower has been calling for people to short the pound since last week. Paul Donovan, global chief economist at UBS Wealth Management, said: “Investors seem inclined to regard the UK Conservative Party as a doomsday cult.”
Whatever happens, it is clear that Truss and Kwarteng have a long way to go in repairing their reputation in international markets, something that will be crucial if they are to make their bold gamble a success.