Inconsistent UK policy will continue to weigh on investor sentiment

Last month, we flagged the possibility of the British pound breaching parity against the US dollar on the back of widening interest rate differentials with the US, a deteriorating economic outlook and uncertainty over fiscal policy under the new prime minister, Liz Truss . In the end, it was the fiscal policy surprise that triggered the disorderly sell-off in sterling and gilts last week, taking the pound down to $1.035 , its weakest level in half a century since the UK adopted the decimalisation of its currency. Kwasi Kwarteng, the new chancellor of the exchequer, outlined a broad change to the UK’s tax regime, scrapping the top level of 45 per cent income tax on high-income earners , lowering the lowest band of income to 20 per cent, from 19 per cent, and also reversing planned increases in national insurance and a payroll tax, as well as a planned increase in corporate tax to 25 per cent, from 19 per cent. The government has also raised the threshold at which stamp duty , a tax on property purchases, takes effect. Markets firmly rejected the plans, with the collapse in sterling the most notable move, but borrowing costs for the British government also surged. The two-year gilt yield jumped by about 120 basis points to a peak of 4.73 per cent while the 10-year gilt yield surged to 4.6 per cent before the Bank of England intervened to prevent the sell-off from becoming a financial crisis, with reports that pension funds were struggling to meet margin calls, forcing them to sell gilts into the declining market. To restore some stability to the market, the BoE announced it would buy £65 billion ($63.7bn) worth of long-dated gilts and delay its planned quantitative tightening until the end of October. There was also some speculation that the BoE would announce an emergency rate increase last week to help shore up the pound, but this seemed unlikely to us given that the BoE had raised rates by only 50 bps on September 22, less than the market had been expecting and displaying a lack of unanimity in its decision. The vote for the 50 bps increase was split, with five members supporting, three voting for a 75 bps increase and one voting for a 25 bps move. That compares with a unanimous decision from the US Federal Reserve for a 75 bps rise at its last Federal Open Market Committee meeting. BoE Governor Andrew Bailey said last week that the Monetary Policy Committee “will not hesitate to change interest rates by as much as needed to return inflation to the 2 per cent target sustainably in the medium term”. The market is now pricing a peak bank rate of 5.6 per cent next year in order to bring inflation back to target and to support the pound. While the pound has recovered some of last week’s losses after the BoE’s intervention and the chancellor’s decision on Monday to reverse the tax cut for high earners, more pain may be in store. On a real effective exchange rate basis, the pound has not fallen that far, unlike the yen or the euro , and potentially has some way to go before it allows for any sustained rebound. Moreover, the credibility of UK government policy has been eroded and this will continue to weigh on investor sentiment. While the prime minister and chancellor initially stuck to their guns on the tax cuts and supply side reforms, they were forced to change tack at the start of this week after many conservative MPs said they would not support the budget legislation in parliament. For a government that has been in place for only a few weeks to have to reverse a major policy initiative within days of announcing it is not a good look, and it will probably not be enough on its own to restore confidence and credibility. Recent polls show the Labour Party taking a big lead over the Conservative Party , which will further erode the PM’s support among her own backbenchers in Parliament. Whether this forces the government to further soften its plans to cut taxes and increase spending in the coming weeks remains to be seen. Khatija Haque is chief economist and head of research at Emirates NBD

Inconsistent UK policy will continue to weigh on investor sentiment

While the pound has recovered some of last week’s losses, after the BoE’s intervention and a partial policy reversal, more pain may be in store