The pound fell to a record low against the U.S. dollar early Monday, fueling speculation that the Bank of England might raise interest rates to prop up the currency.
The sterling fell almost 5 percent to drop below the 1985 trough at $1.0327, before recovering to $1.0605. It was still down around 1.5 percent around midday on the session.
On Friday, the pound fell more than 3.5 percent against the dollar, after the new government announced the biggest tax cuts in 50 years.
Investors are not impressed by debt-financed tax cuts at a time when interest rates are on the rise. They also sold off U.K. government debt.
Commerzbank economist Bernd Weidensteiner described the market reaction as one that is more typical of an emerging-market economy. Rather than supporting the pound by boosting growth expectations, aggressive fiscal spending “in this case, a much more expansionary fiscal policy raises fears about the sustainability of the new debt to be taken on and increases the risk of a balance of payments crisis.”
Paul Johnson, director of the Institute for Fiscal Studies, said the government showed not “even a semblance of an effort” to make the public finance numbers add up. “Instead, the plan seems to be to borrow large sums at increasingly expensive rates, put government debt on an unsustainable rising path, and hope that we get better growth,” he said.
The difference in interest rates investors demand to buy British rather than German 10-year government bonds rose to the highest level since 1992 when speculation against the pound forced the U.K. to drop out of the European Exchange Rate Mechanism (ERM).
ING economist Antoine Bouvet said plans by Chancellor Kwasi Kwarteng had created “a perfect storm for U.K. gilts and FX.”
The problem may now be the Bank of England’s to fix: “Kwarteng threw the BoE a bomb and now they have to respond — today, [ASAP] … rate hikes incoming,” said Chris Weston, head of research at Pepperstone.
Former Bank of England Monetary Policy Committee member Adam Posen also expects rates to go up, after a possible, futile attempt by the Treasury to intervene in forex markets to prop up the pound. “But I would expect — and encourage — the Governor/MPC to say publicly by mid-week that if GBP down, rates up,” he tweeted.
Markets have significantly ratcheted up their interest-rate hike expectations and now expect rates to rise by 1.5 percentage points by November this year and peak at 6.25 percent by November next year. Some bets are in for a first hike as soon as Monday.
The Bank of England on Thursday raised rates by 50 basis points to 2.25 percent and made explicit reference to a pending announcement that would likely “contain news that was material for the economic outlook.”
A falling pound is a particular concern for the Bank of England, as it challenges its fight against rampant inflation by boosting the cost of dollar-denominated energy imports. The lower the pound, the more interest rates have to rise.
In an interview with the Financial Times over the weekend, Kwarteng dismissed concerns over the ensuing market turmoil. “Markets move all the time. It’s very important to keep calm and focus on the longer-term strategy,” he said. Nor did he see a conflict between the Bank of England’s tightening of monetary policy to control rampant inflation and the fiscal authority’s spending spree.
Shadow Chancellor Rachel Reeves, in contrast, told BBC Radio’s Today program that the drop in the pound is “incredibly concerning,” as it will push up consumer prices as well as the government’s borrowing costs.
“Here’s the thing; they are not gambling their money, they are gambling all our money,” she said, referring to Kwarteng and Prime Minister Liz Truss.
The euro also hit a 20-year low against the greenback to trade at $0.9647, as the victory of a right-wing coalition in Italy on Sunday compounded lingering recession fears.
This article has been updated.