The recent sharp drop in the British pound and in U.K. government bonds means traders are at panic stations, with repercussions being felt across the globe.
The spectacular drops in the past month were sparked by a dramatic policy decision to borrow billions to cut taxes to supercharge growth. But they are the culmination of years of deterioration.
The unexpected market reaction has left new Prime Minister Liz Truss and Bank of England Governor Andrew Bailey with few good options.
Emergency rate hikes, rebellions against the government and even an intervention from the International Monetary Fund are being mooted as possible ways out of the crisis.
To understand how the world’s sixth largest economy finds itself in such a dire predicament, it is worth looking at its past period of woes.
As documented by the strength of the pound, the U.K.’s fortunes have fallen in fits and starts for 15 years. In late 2007, a pound bought more than $2. Strategists now predict it will soon fall below parity.
Its decline started with the financial crisis, which hit Britain and its outsize banking sector particularly hard. Almost overnight, the country went from having one of the strongest productivity growth rates—a big underlying driver of overall economic expansion—to one of the weakest among advanced nations. The pound fell 26% in 2008 to about $1.50.
In the aftermath, Britain experimented with the doctrine of “expansionary austerity,” or the idea that cutting public spending in the depths of an economic downturn would eventually boost growth by increasing confidence. It didn’t work, and Britain’s recovery from the crisis was slower than most.
In 2016, the currency slipped another 16% to $1.23 after the U.K. voted to leave the free-trade zone of the European Union. Investment spending tanked for years as companies dealt with the uncertainty of how big the new barriers with its biggest commercial partner would be.
It also led to a quick churn of governments, albeit all led by the ruling Conservative Party. Then-Prime Minister David Cameron handed over to a new leader Theresa May after the Brexit vote.
She was replaced by Boris Johnson in 2019, who called a snap election and won a bigger majority on the back of a simple campaign to Get Brexit Done. Johnson’s version of Brexit promised to diverge from European regulations which meant a big increase in barriers to trade.
Then the pandemic hit, which bogged down the economy yet again. Between 2017 and 2021, the pound went as high as $1.42 and as low as $1.15.
When Johnson was removed as prime minister following a series of setbacks this year—including having drinks with colleagues in his office while the country was in lockdown—his successor Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng decided that the years of economic stagnation had to come to an end.
“We just had 10 to 15 years of appalling growth,” said Duncan Weldon, an economist and the author of the book Two Hundred Years of Muddling Through: The Surprising Story of the British Economy. “They had a good argument that we should change tact rather than keep doing the same things and getting the same outcomes.”
Within weeks of taking office, Kwarteng announced the biggest set of tax cuts since 1972 as the path to restore the country’s fortunes. The theory is that a wave of reforms would unleash productive capacity and increase output faster.
Regardless, markets were spooked because the cuts were bigger than traders had expected from a series of leaks, and it’s not clear that the measures announced so far will do much to lift the supply side of the economy.
Truss may be trying to follow in former Prime Minister Margaret Thatcher’s and former U.S. President Ronald Reagan’s ideological footsteps, but reducing a government’s tax take has a mixed record in impacting economic growth.
“If you look across developed countries, there isn’t really a good correlation between output per head and the size of the state,” said Tony Yates, a former Bank of England official. “America is extremely wealthy and has a fairly small state. But that doesn’t mean that’s what we should do.”
The second problem is that even if the tax cuts are effective in increasing supply, the impact will take time, and their immediate effect is to increase demand. The tax cuts have also come on the heels of Truss’s plan to cap energy bills for households and businesses this winter, which amounts to even more fiscal stimulus.
And here’s the crux of the issue. The Bank of England is desperately trying to raise interest rates to get the fastest inflation in 40 years under control. It means that the government and the central bank are pulling the economy in different directions, and that never ends well. Markets now expect that the central bank will have to move rates higher than before the measures were announced.
Traders responded with a massive selloff in the pound and U.K. government bonds. The currency fell to a record low $1.03 on Monday before settling at about $1.08. A pound bought $1.17 at the end of August. The 10-year gilt yield spiked by half a point, and the five-year gilt yield went even higher than the 10-year.
This has now shifted expectations to how the crisis might play out.
It triggered traders to price in emergency rate hikes before the next scheduled meeting. If this happened it would be a first since the central bank gained independence in 1997.
George Saravelos, a strategist at Deutsche Bank, says traders expect the BoE to lift its benchmark by almost 2 percentage points before the scheduled Nov. 3 rate setting meeting, with a terminal rate of 6%. The current rate, arrived at after a half-point hike in August, is 2.25%.
“If this isn’t delivered, it risks further currency weakening, further imported inflation, and further tightening, a vicious cycle,” Saravelos wrote in a note. But the steep BoE hikes are unlikely to happen because “it would push the economy into a very deep recession.”
In what has been a period of intense turmoil the BoE and the Treasury were forced to respond to pressure, releasing coordinated statements on Monday. The central bank said it wouldn’t hesitate to move rates as needed. The Treasury brought forward plans to announce a bigger package of reforms to November and said they would be analyzed and costed by independent agencies.
But the damage to their credibility has been done, and Truss and the BoE’s Bailey have few good options now. Politically, Truss can’t afford to backtrack on her plans, but any further bold steps may face opposition from her own party following the unpopularity of the first round.
The BoE, due to publish new forecasts next month, risks looking like it has lost control if it moves rates up before the scheduled date. And no matter how big an increase, it would probably leave markets wanting more.
An inter-meeting cut “would do more harm than good,” said Yates, who worked at the central bank for 20 years.
Currency interventions along the lines of what Japan did to stem the weakness of the yen are also out of the question, according to Weldon. Not only does the U.K. not have enough reserves to get far with such an effort, the experience of getting kicked out of the European Exchange Rate Mechanism in 1992—the last time the government tried to boost the pound with purchases—has left scars, he said.
With weeks to wait before the central bank’s next decision, gilts and the pound feel like a powder keg waiting for a spark.
Lawrence Summers, Treasury Secretary under Bill Clinton, predicted a grim future in a series of tweets on Tuesday.
He said the pound will fall below parity with both the dollar and the euro, while short-term U.K. interest rates will triple to more than 7%. A crisis in Britain will hurt London as a financial center and the International Monetary Fund may need to get involved to prevent spillovers to other countries, he tweeted.
That would be the ultimate humiliation.
The U.K. last needed a bailout loan from the IMF in 1976. It’s hard to imagine things getting that bad again. Such an event would make victory for the opposition Labour Party at the next election in two years almost inevitable.
Truss’s fellow party members may rebel if markets continue to reject her agenda. Members of Parliament could also be prompted into action out of fear that rapidly rising interest rates will make mortgage payments unaffordable for a nation of homeowners.
“There’s a lot of attention on sterling being volatile, but what’s happening with interest rates matters a lot more,” Weldon said.
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