Kwarteng crushes the pound

The never-ending give away during today’s “Fiscal Event” in the UK has had one immediate impact, it has sent the British pound down to its lowest level since the early 80s. For FX purists who believe that a currency reflects the outlook for a country, then the UK’s prospects have sunk to levels last seen pre–Margaret Thatcher’s ‘Big Bang’ that kick-started London’s financial sector. The irony is that Kwarteng did everything possible to help the City of London, including scrapping limits to banker bonuses (not an altogether bad plan, although the optics don’t look good right now), and scrapping the top rate of income tax. So, why has the pound plunged nearly 2% on the back of Kwarteng’s not-so-mini-Budget, what are the implications and what is the end game for GBP?

How Kwarteng torpedoed the pound

It is worth noting that GBP/USD’s massive 1,200 pip sell off in the last 6 weeks is not a managed de-valuation by the government; the Bank of England is actively hawkish and raising interest rates and the currency is still in free fall. Instead, it is a de-valuation by the market. This is serious, the UK government on Friday did not look like it was remotely worried about the weakness in the pound. What’s worse for pound bulls, is that Trussenomics seems to have accelerated the move lower in the pound. Friday’s move was significant, because GBP/USD is fast approaching the key $1.10 level, which is a psychologically important barrier to the pound reaching parity with the USD. So, what is driving the pound lower, and why might the new UK Chancellor have put a stake into the heart of sterling?

·      Rising debt levels don’t have to hurt an economy. Instead, it all depends on a balance between supply and demand. If government debt boosts demand (i.e., consumer or business demand), then government spending must boost supply by an equal amount. When this happens, a rising debt burden is sustainable. The problem comes when these two are out of balance.

·      The latest tax giveaway by the government is boosting demand: the energy price cap, scrapping the highest rate of income tax, the stamp duty cut, along with a raft of other measures, is set to cost the UK economy £45bn. Essentially this budget was an enormous tax cut funded by debt finance.

·      This is the biggest tax-cutting event since the early 1970s.

·      Measures that were announced that could boost supply included investment zones, freezing corporation tax and other vague plans to boost infrastructure investment, however these were long term plans that were not fleshed out and do not seem to be on par with the boost to the “demand” side.

·      Measures that could have boost supply, but Kwarteng left out, include a VAT cut and a liberalisation of immigration and/ or labour market rules to ease the labour market shortage and put downward pressure on wages. He could have also helped to mute the supply side boost by announcing a windfall tax on energy company profits. Thus, from a fiscal perspective, supply and demand fuelled by government debt is now out of balance.

·      When an ‘imbalance’ occurs, in this case a shortfall in supply, there will be an automatic readjustment, or transfer, to reduce the purchasing power of one or more sectors.

·      A key “transfer” of purchasing power is currency depreciation, which is why the pound is falling so sharply. This shifts the “adjustment” cost onto the domestic importers, which is fuelling inflation in the UK and reducing consumers’ and businesses’ purchasing power, thus neutralising some of the boost to demand.  

·      Another way to adjust this “imbalance” in the UK economy is to push up interest rates and the unemployment rate. The interest rate rise is happening already: 2-year Gilt yields are up more than 30 basis points, while the 5-year yield is up nearly 50 bps. This is not a normal move.

The end game for the pound

At this stage, the pound is finding some support around $1.10, but for how long? The trade weighted pound is down more than 2% on Friday, after reaching a record low on Thursday. I have never witnessed moves of this magnitude. There is no history to fall back on, the outlook is deeply uncertain, which probably means more selling of the pound and a break of $1.10 with a move back towards parity. Is the pound’s decline really keeping up with the narrative, or has the market run ahead of itself? When it comes to the FX market, we believe that there is a bit of both, however this is a grave situation for the pound.

One definition of an emerging market country/ currency is when the currency and bond market weakness go hand in hand. Thus, the pound is falling because the rest of the world perceives fiscal irresponsibility which is undermining the UK currency. On the plus side, if the UK economy is to grow, then businesses will have to invest. Friday’s move lower in the pound could make the UK a cheaper place to invest than elsewhere, along with scrapping the top rate of income tax and other incentives for investing. However, the UK attracts a relatively low rate of investment compared to other G10 nations, so this will require a massive change in global investment patterns for it to help the UK.  Another glimmer of hope for the UK in the long term is that tax cutting and slashing the regulatory burden at the same time as rising interest rates has worked in the past. But this will not make life easier for the pound, although it may ease selling pressure in UK stock markets.

Friday’s move in the pound and the bond market is close to crisis levels. For example, how much higher can we go in UK gilt yields before this is considered a crisis? If that happens, then maybe it will trigger a general election, a change of government and a very short-lived experiment with Trussonomics. That could be when the pound turns.