Pound all-time low has market eyeing emergency rate hike

The run on the pound: Sterling plunged to an all-time low against the US dollar in Asian trading before paring some losses as confidence in the UK’s fiscal policy went up in smoke. GBPUSD slipped almost 5% to 1.035 in a brutal 20-minute selloff in the early hours, extending its run lower from Friday after the chancellor announced sweeping tax cuts. The judgment of the market to the new fiscal policies is obvious enough; the bond vigilantes have returned with a vengeance. Following the initial sell-off we’ve seen cable bounce back to above 1.07 but it’s clear there is no love for the pound. The FTSE 100 was sharply lower on Friday amid broad based selling of stocks, but the softer pound is giving it some respite this morning as European stock markets trade generally lower. The domestically focused FTSE 250 was about 0.7% lower in early trade as confidence in UK plc evaporates. And there is no let-up in the bond market; gilts are off sharply with the 10yr yield jumping above 4.2%, its highest since 2008, and 2yr north of 4.4%. Very swift and very aggressive repricing in the last two sessions. Ok so markets have a habit of overshooting on the way up and the way down – but gilts and sterling probably have further to go here.

Does the Bank of England intervene? Talk is of an emergency interest rate hike by the Bank to steady the ship. Traders now price in 150bps of hikes by the BoE by November, implying an expectation it comes out with a hike before the next meeting. The central bank is in a tough place and any intervention might only be a sticking plaster as the path of least resistance for the pound is lower; parity gravity. Despite this, to not act would be wilful neglect. Just as the chancellor has taken a reckless approach to fiscal policy – a kind of economic vandalism – the BoE needs to take a very considered approach to monetary policy. Bailey’s tenure will be remembered for this moment. Inter-meeting hikes can look like panic and Bailey is not one to react very swiftly, and direct intervention in FX markets is impossible due to lack of reserves. So, it would need to be a big hike – 100bps would be about right – but then what happens if this does nothing. Jawboning with some hawkish rhetoric might send yields even higher and lead to further pound losses...a tough spot. If the BoE stands idly by as the pound craters it would be as guilty as Kwarteng. But it might hope that sterling rights itself and recovers before it needs to say or do anything: the parity gravity makes this rather risky.

Basic rules for any chancellor: don’t cause a panic in the markets and don’t cause a run on the pound. Simples. But now policy is now adding to volatility...soaring gilt yields (higher borrowing costs) and a falling pound are the worst possible combination for the government and for the UK as a whole and yet that is exactly the macroeconomic path being pursued by the Chancellor and PM. It’s not like there could be any other kind of reaction when gilt issuance needs to rise drastically to fund it all as there are no spending reductions to offset the loss in tax.  

Kwarteng is not exactly doing anything to address the market reaction. He promised "more tax cuts to come" and refused to put a limit on how much the government might borrow. On Friday he said it was a “good day” for the UK. 19 days in and he’s wrecked the gilt market and sent the pound on the run….not an inspiring start. The question is at what point Tory backbenchers turn on the leadership. I reiterate that sparking a run on the pound is the sort of thing that brings down governments – and rightly so! Does Kwarteng even understand how financial markets work? It does not appear he does.

Of course, it’s not entirely sterling and the tax cuts – the euro is also under the cosh and slipped even further overnight as sterling fell. Overnight EURUSD dipped to 0.9550, a new 20-year low, whilst the dollar index rallied above 114 for a new two-decade high. But if we look at euro-sterling, it’s obvious the market is giving the chancellor a thumbs down. Sterling also dropped abruptly against the euro, with EURGBP hitting a two-year high this morning above 0.9250. 

Meanwhile, Meloni’s centre-right coalition heads for a comfortable majority in parliament after voting in Italy on Sunday. There has not been a massive reaction in markets to this since polls have been telling us this would happen for some time. The FTSE MIB is firmer this morning, rallying 0.75% in early trade to outperform peers.  

Brent crude fell below $85 a barrel as markets fretted over the global economic outlook and the dollar surged to its highest since 2002. Brent futures fell to their lowest since January, wiping out all the gains made since the Russian invasion of Ukraine.