British government bonds sold sharply and the pound hit a new 37-year low against the dollar as investors feared Kwasi Kwarteng’s tax cuts and energy subsidies would put Britain on an “unstable” fiscal trajectory.
10-year government bond yields rose 0.27 percentage point to 3.77 percent on Friday, marking the increase for the week to more than half a percentage point. This week’s rise marks one of the largest ever rises in the cost of long-term loans. The British pound fell below $1.11 for the first time since 1985, while the FTSE 100 stock index fell 2.4 percent on Friday.
Friday’s heavy sell in gilts and the pound came after Kwarteng, the chancellor, said the government would scrap the top 45p income tax rate and replace it with a 40p rate. He also announced a reduction in stamp duty on home sales.
The tax cuts, which will reduce government revenues, come as the UK is expected to spend £150 billion on subsidizing energy costs for consumers and businesses. Kwarteng said the energy bailout would cost £60 billion in the first six months.
A large part of these loans will have to be financed by the sale of gilts. The UK Debt Management Office increased its planned bond sales for fiscal year 2022-23 by £62.4 billion to £193.9 billion.
“This massive fiscal event is a radical economic gamble; a ‘go big or go home’ gamble that will put UK debt on an unstable footing,” said Bethany Payne, bond portfolio manager at Janus Henderson Investors.
Investors also expect more aggressive rate hikes from the Bank of England to offset the inflationary impact of Kwarteng’s stimulus measures, following a 0.5 percentage point hike in bank interest rates this week. Expectations for more aggressive BoE rate hikes caused two-year government bond yields to rise more than 0.8 percentage points this week.
Following the chancellor’s announcement, markets expected a rise of 0.75 percentage points for each of the next three BoE meetings, pushing interest rates to 4.5 percent.
To increase pressure on UK government bonds, the BoE also announced Thursday that it would begin selling government bonds it owns next month as a result of past bond-buying programs in an effort to shrink its balance sheet.
Payne said Friday’s loan announcements would make it even more difficult for investors to absorb gold sales from BoE, raising the possibility that the so-called quantitative tightening will be “over before it has even started.”
The pound on Friday extended its recent fall, falling as much as 2.1 percent after Kwarteng spoke, reaching a low of $1.1022, a level last seen in 1985, according to data from Refinitiv. The pound fell 1.1 percent against the euro.
“In this kind of environment with the cost of living crisis, energy crisis. . . the likelihood of policy slippage is increasing,” said Stephen Gallo, head of European FX at BMO Capital Markets. “The coin will show a lot of the burden and it is doing so now.”
The combination of the gold market defeat and a fall in the pound – which should normally benefit from higher interest rates – sends a “worrying” signal that investor confidence in UK economic policy could be dwindling, said Mike Riddell, a portfolio manager at Allianz Global Investors.
“Saying that the UK will be an emerging market is still clearly a step too far – there are still strong institutions. But it’s a slippery slope,” he added. “The danger is that if the market decides you’re going down the road of essentially doing the wrong policy — launching a huge fiscal stimulus when you have double-digit inflation — you lose credibility built over decades.”
Additional reporting by Chris Flood