By Ugo Lancioni, head of global currency at Neuberger Berman
The market reaction to the tax cuts announced on Friday has been extraordinary.
On Monday morning, the yield on UK government bonds was almost 110 basis points higher than before the budget announcement. At one point during Asian trading hours, the British pound had dropped more than 8% versus the US dollar. Key technical levels were broken (1.10 for the pound/dollar)with margin calls and the triggering of options causing further volatility in FX and rates.
When both currency and the bonds face this kind of selling pressure, the market is sending a clear message of no confidence to policymakers.
Bank of England Governor Andrew Bailey was forced to release a statement saying that, “The [Monetary Policy Committee] will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term” in order to stabilise markets.
With the current account expected to drop further below 6% of GDP and the budget deficit approaching 5%, the market is demanding higher rates and a cheaper currency to finance the widening twin deficit. The lack of Office of Budget Responsibility forecasts has only added to the market’s loss of confidence in the UK’s creditworthiness.
Inflation has surprised to the upside everywhere and US dollar strength is becoming a headache for global central banks. And while all major economies have seen meaningful revisions in growth expectations, the 2023 growth outlook for the UK has been worsening faster than for any other major economy. Since the beginning of the year, growth expectations have dropped by almost 2.5 percentage points], ending in negative territory.
The energy supply shock has prompted a terms-of-trade crisis for all energy importing countries. The US dollar is probably entering an “overshooting” phase driven by risk aversion, lower global growth and higher US real rates. Despite its debt-to-GDP of around 100% not being far from other major economies, the UK is simply more vulnerable than in the past. The unfunded fiscal package was only the trigger.
In our view, UK policymakers must avoid a vicious circle where currency depreciation increases inflation, leading to higher interest rates and lower growth, leading to more currency depreciation, etc.
An improvement in global risk sentiment would certainly help the UK but the biggest risk for the government is that the aggressive tax cuts will not deliver the growth required to keep debt sustainable if global growth deteriorates further. Fiscal discipline will be on the radar screen. In the meantime, higher rates are needed to stabilise the market: 320 bps are priced in the curve for the next six months. The Bank of England might be tempted to review its quantitative tightening plans if further stabilisation is required.