Whither the Pound?

15 mins. to read
Whither the Pound?

Crisis? What crisis?

The foreign-exchange and gilts markets evidently did not care very much for Kwasi Kwarteng’s ‘fiscal event’, which I contextualised last week.

Just after the chancellor sat down last Friday, the pound fell to £1.09 and lurched downwards for the rest of the trading day. Then, when the foreign-exchange markets opened in Asia last Sunday night/Monday morning, the pound retreated to its lowest-ever level against the dollar, briefly touching $1.0350 in volatile trading. That is unprecedented. Even in the currency crisis of 1985 the pound remained just above $1.05. However, sterling rallied, and finished in London at $1.08 after a joint intervention by the chancellor and the governor of the Bank of England (BoE), which had a whiff of the “whatever it takes” moment in the European sovereign-debt crisis. Essentially, they pledged that sterling interest rates will rise imminently in response.

On Wednesday, the rout continued, with the pound falling below $1.06 in European markets as gilt prices tumbled. The BoE was forced to intervene by furiously buying up government debt in order “to restore orderly market conditions”. There was talk of “dysfunctional markets”, which is always code for “don’t panic”. That was a reversal of the policy of quantitative tightening – selling about $80bn of gilts − which had been signalled very recently. The pound closed above $1.07 and gilt yields eased.

The cause of the financial markets’ dismay at the financial-strategy debut of the Truss government is clear. Last Friday’s fiscal event (the word “budget” was conspicuously avoided, presumably to avert the scrutiny of the Office for Budget Responsibility) opened the way for £45bn in tax cuts next year plus the additional spending of around £100bn to cover the Energy Price Guarantee (EPG). The EPG will cap energy prices for households, businesses and public institutions such as hospitals and schools.

True, much of the £45bn was attributed to reversing Rishi Sunak’s hikes in corporation tax and national-insurance contributions. Kwarteng told us in his statement that the Treasury had estimated that the EPG would cost £60bn in its first six months alone – though we have little idea how much it will cost over its proposed two-year life because we don’t know what gas prices will be next year. Hopefully, they will be lower than today, but that is uncertain.

Putting these two things together – and without underlying analysis from the OBR – the markets have made a ‘back-of-an-envelope’ calculation that the UK fiscal deficit will double from around £150bn in 2021-22 to around £300bn in 2023-24. To put that in context, as a result of the coronavirus-pandemic lockdowns, the furlough scheme, the roll-out of the vaccination programme, the miserable ‘test and trace’ programme and so on, the fiscal deficit in the year ending 5 April 2021 was £318bn or 14.8 percent of GDP. Yet there was no sterling crisis in the spring of 2021: on the contrary, sterling remained robust. Why has market sentiment changed so violently this time?

Simply put, back then we were still living in the ‘La La Land’ of near-zero interest rates and stable prices; now rates are rising rapidly in a period of rampant inflation. This means that the cost of servicing the government’s debt is about to soar, further damaging national finances. Last week I observed that, as Kwarteng concluded his 30-minute ‘bombshell’, the 10-year UK government bond was yielding 3.5 percent as gilt prices were marked down. Considering that the BoE had hiked rates by 50 basis points the day before, that did not represent a severely adverse market reaction. By Tuesday, however, the yield was up to 4.135 percent; and by Wednesday above 4.2 percent. So, the UK government must now pay more to raise new funds than Italy or Greece. The risk-return ratio calculation has fundamentally changed.

If the UK government had to pay four percent on its entire stock of debt – which was £2.365trn at the end of March and is almost certainly higher now – the debt-interest cost alone would be just under £100bn. That is almost as much as the government spent on education last year and is up from just £45bn in 2021-22. So, the back-of-the-envelope calculation might then be that the 2023-24 fiscal deficit would more likely be nearer to £350bn than £300bn. Presumably, by the year of the next general election, the national debt will then be nearer to £2.8bn given that the current year deficit is likely be around the £100bn mark. Yet, given sloth-like and possibly negative growth, the debt-to-GDP ratio might have risen to around 117 percent – an astonishing deterioration in the public finances. And as the debt burden rises –– so the interest cost will continue to spiral upwards. That is where a ‘gilt strike’ becomes a distinct possibility.

There is another worry. As gilt prices fall in the open market, so the balance sheets of pension funds are adversely affected. Some may even be pushed into deficit. That is as much a worry as the weakness of the pound and was manifest on Wednesday.

Supporters of the Truss-Kwarteng strategy argue three points for reassurance. Firstly, in terms of the national debt-to-GDP ratio, the UK is currently still at the lower end of the G-7 economies. They think it’s perfectly acceptable to join the ‘One Hundred Club’ (countries which have a debt-to-GDP ratio in excess of 100 percent). Second, unlike in many countries, UK government debt is overwhelmingly denominated in its domestic currency – so the devaluation of the pound does not impact the cost of debt service. Third, much of the UK’s national debt is in the form of long-term instruments (up to 30 years in maturity) which will not have to be refinanced anytime soon with higher coupon issues.

Opponents point out that a significant proportion of outstanding debt is in the form of index-linked securities which mirror the rate of inflation. And almost no one believes that the Truss-Kwarteng growth target of 2.5 percent will be achieved within this parliament. Certainly not Moody’s, which is about to put the UK on its “negative outlook” list.

In response to the prospect of rapidly rising interest rates, most domestic-mortgage lenders withdrew their fixed-rate deals at the beginning of the week − some like Skipton Building Society and Virgin Money even cancelled outstanding mortgage offers. An estimated one thousand mortgage products have been discontinued. If the mortgage market shudders to a halt, that would more than offset any stimulus to the housing market from the reduction in stamp duty. Some mortgage holders whose fixed-rate deals expire over the next year face the prospect of their monthly payments doubling. This will exacerbate the cost-of-living crisis experienced by much of the population. We shall be hearing much more about this if, as predicted by the futures market, the base rate reaches six percent by next May. Mortgages tend to be a lot bigger today than when interest rates were last at six percent – and mortgage interest is no longer tax deductible.

On the other hand, we might be on the cusp of savers being rewarded once again. That would be a fillip for many pensioners with modest cash nest eggs. And, as I have argued here before, a regression to historically “normal” interest rates will result in better capital-allocation decisions.

International reaction

A plethora of internationally influential commentators have disparaged the fiscal event and the Truss-Kwarteng economic strategy. Ray Dallo, founder of Bridgwater Capital told the BBC’s Today Programme on Wednesday morning that the UK’s new Tory government had fundamentally miscalculated. And that same morning, in an unusually opinionated announcement, the Washington-based IMF claimed that the UK’s fiscal package would aggravate the cost-of-living crisis and would deepen inequality. The IMF urged the UK government “to re-evaluate”. The IMF does not normally comment on fiscal policy in advanced economies.

For Truss supporters these comments were predictable. Sir John Redwood MP decried the IMF as the mouthpiece of economic orthodoxy which had failed to predict the inflationary ‘tsunami’ which has engulfed all advanced economies. He and others argue that the fiscal package is only half the story: countervailing measures will be revealed in a “medium-term fiscal plan” on 23 November, which will entail critical supply-side reforms. But why weren’t the supply-side reforms announced before the tax cuts? Lord Frost told the Daily Telegraph that: “The IMF has consistently advocated highly conventional economic policies. It is following this approach that has produced years of slow growth and weak productivity”.

According to economist Yanis Varoufakis, the real significance of the sterling crisis is that Washington and Brussels fear a financial contagion that could infect the bond markets in the US and Europe. That could trigger a systemic financial crisis. And that is why they want the UK to change course urgently.

Political risk

Last week I wrote, not entirely flippantly, that: “The real reason why the pound is falling in my opinion is that the money men think that the Tories will lose the next election”. One reader – Tom – wrote in to ask me what planet I was living on.

In all seriousness, foreign-exchange trades are driven by short-term newsflow, which is largely political in nature, rather than by in-depth economic analysis. Over time, serious analysis informs the newsflow, so over the medium term there is a corrective. But a perception that a government has lost its reputation for financial competence overnight can be hugely damaging; and the prospect of something even more uncertain on the horizon is disturbing for traders. What is exceptional about this sterling crisis is that the currency is weakening even as interest rates are rising – something normally associated with emerging-market currencies.

I resisted the temptation to be partisan in the recent Tory leadership contest. I thought it was regrettable that it was happening at all, even if I had grave reservations about the leadership of the outgoing prime minister. But it was always clear that Sunak was the continuity candidate offering essentially more of the same though in more brightly coloured packaging, while Truss was the radical who wanted to ‘think outside the box’ (or at least outside the “Treasury View”).

As such, Truss was always going to be higher risk than Sunak. The Tory membership, in its wisdom or otherwise, decided that it was time for the ship to change course. But even those who desired a radical departure from the pseudo-Brownite policies of the Johnson-Sunak government might have preferred that the package in the fiscal event had been delivered more subtly.

Let’s take the scrapping of the higher rate of income tax of 45 percent on incomes above £150,000. It was Nigel Lawson’s budget of 1988 that abolished the 60-percent band and set the upper rate of income tax at 40 percent. For the 10 years of the Blair government, the highest rate of income tax remained at that level. It was the Brown-Darling government that increased the higher rate of income tax to a performative 50 percent in the wake of the financial crisis of 2008-09. Then the Cameron-Osborne government reduced the higher rate to 45 percent – and tax receipts rose as a result.

Arithmetically, scrapping the 45 percent tax rate will cost just £2bn – a paltry sum in the scheme of things. The argument that the total tax take from high earners such as bankers and hedge-fund managers who relocate from New York and elsewhere to London will inevitably rise is credible. Politically, however, announcing the scrapping of the higher income-tax rate at the same time as binning the cap on bankers’ bonuses was easily interpreted as indulging the rich at the expense of the poor. And that was the dominant narrative at the Labour Party Conference in Liverpool this week.

Margaret Thatcher understood that even radical reformers do not change everything at once. Change is best undertaken incrementally. Her initial priority was to slay inflation and retrench the national finances; only later did she start a crusade to privatise state-owned industries and to slash taxes.

First impressions are important. And it is not just the financial markets that have formed negative first impressions of the Truss-Kwarteng government. Voters are disenchanted too. According to a YouGov poll published on Tuesday (27 September) Labour is now 17 points ahead of the Tories. That buoyed Labour delegates in Liverpool.

Betfair is now offering implied odds of 1.62 (5/8) on that Labour will win most seats at the next election while the Tories are at 2.56 (8/5) on. So, the bookies think Labour is going to win the next election. If Labour were to form an electoral pact with the Liberal Democrats, those odds would shorten further in Labour’s favour. So much for Tory MPs rejecting their former leader because they thought he was a liability.

The government has now instructed the major spending departments to find “efficiency savings” – a vintage euphemism for spending cuts. Even if they were significant, they would come too late to assuage the financial markets. And any cuts in public services, overlaying the cost-of-living crisis, will inevitably be unpopular. The narrative will be that the Tories are underfunding the NHS to fund tax cuts for the rich.

There are some Thatcherites who say: “Let the exchange rate go where it will”. The memory of the (European) exchange rate mechanism (ERM) from which the pound was ejected 30 years ago this month still rankles. John Major’s government never recovered from that debacle.

But even commentators like Charles (Lord) Moore, Thatcher’s biographer, think that if the pound falls below dollar parity, that would be a humiliation from which this government could never recover. Labour concluded its conference on an exuberant note: its supporters really believe that the Tories are finished (for now). Labour’s conference began with the national anthem and ended with a pledge to maintain “fiscal responsibility”. Meanwhile, the prime minister remained invisible until Thursday when she gave interviews to seven BBC local-radio stations. The British public still knows almost nothing about her. There seems to be a communications vacuum at the heart of government.

She will have a chance to pitch her game plan at the Conservative party conference in Birmingham next week – but where will the pound be then? I hear on the grapevine that about 20 Tory backbenchers have already written to Sir Graham Brady, chairman of the 1922 Committee, to record their lack of confidence in Truss. By the time she speaks, her premiership may already have been broken before it had barely started.

At a parliamentary level, it is far from certain that the finance bill will be able to pass through the House of Commons. I wager that a significant number of Tory backbenchers will vote against it. Any business wanting to invest in or relocate to the UK will now stall because political risk is such that the outlook for the tax regime looks more uncertain than ever. That political risk is now built into the value of sterling.

Blame the bank

There is a school of thought within Tory circles that the main culprit in the currency crisis is not the chancellor but the governor of the BoE. The principal reason why the US dollar has been surging ahead of all major currencies this year is that the Fed has been robustly raising rates in advance of central banks in Europe and East Asia. The accusation is that the Bank started to raise rates much too late – even when inflation had reached five percent and was rising; and that last Thursday’s hike of 50 basis points was insufficient when the City was expecting 75 basis points.

Reportedly, plans to reformulate the Bank’s mandate have been delayed until the spring of 2023. On Thursday, former Governor Mark Carney told the BBC that the Treasury had “undercut” the established institutional framework by not providing the numbers which underlay the fiscal event. His comments have hit home: it seems that the prime minister and chancellor will finally meet the OBR today.

For all the criticism, the Bank’s intervention in the gilt markets on Wednesday was regarded as decisive. What had occurred was that numerous institutional investors, including reportedly Legal & General (whose shares are down by 16 percent this week), had been forced to liquidate some of their gilt positions in order to raise cash to meet margin calls on holdings of futures contracts. Such holdings reside on the balance sheets of so-called liability-driven investment funds which institutional investors use to hedge themselves against adverse movements in rates and to match assets with liabilities. That sent gilt yields soaring. The Bank has now pledged to buy in excess of £50bn of long-dated gilts every day for the next two weeks up to 14 October. Parliament will reconvene on 11 October – so the Truss government has been given some breathing space.

But at the end of this week there is a perception that the Treasury and the Bank are singing from different hymn sheets – and that itself is further undermining market confidence.


In the financial universe, foreign-exchange dealers are not known as the most thoughtful agents, even if one can never argue with the market. People who say – and there are many – that the market has over-egged the negative sentiment may have a point; but the market is never wrong. It just encapsulates the totality of sentiment at a particular moment: whether based on perfect information − or most likely not.

Therefore, to glimpse the future we should not ask the traders but the bookies. I note that Intelligent Gambling (IG) tracks client sentiment. This morning, 59 percent of IG clients were net long and 41 percent were net short on sterling. Therefore, IG is bullish on sterling-dollar. But that is down from 65-35 yesterday afternoon and could change again rapidly. The pound has been trading in the $1.1100 to $1.1150 range this morning.

My hunch is that the pound will recover somewhat but will remain lame. If I doubt that the pound will go to dollar parity, I also doubt that the Truss-Kwarteng government will ever command the markets’ entire confidence. It has made a most inauspicious start.

The Tories’ star is waning – next week’s Conservative party conference will be more critical than any that I can remember. Soon, I’ll take a look at what a Labour government will mean for investors. I strongly suspect that Labour will fight the 2024 election on a platform of “fiscal responsibility” – and of rejoining the European single market.

The melodrama continues.

Comments (2)

  • Andy says:

    I also find it strange that the financial news correspondents on TV haven’t mentioned the fact that Sterling is so weak because Labour are likely to win the next election. I can only presume that Tom is very young and does not remember the terrible state of the country the last time Labour were kicked out, or the time before that and the time before that. At the current time the Labour Party and the whole of their cabinet are unknown and totally inexperienced, which doesn’t bode well yet again for the future.

  • Paul says:

    As a Brit, now in the Greek islands, the pounds fall to 1.03 usd was emotional.
    Though hedged in gold usd and euros it is never enough.
    Then there was the double whammy of Nord stream 2 sabotage and don’t you dare Italy Vote for Georgia from Ursula Wonderland in the EU. And the euro was so tame?………..me smells a big rat. Who was selling the GBP early Sunday morning ?
    The same crowd that sabotaged the Nord Stream……..was the GBP a diversion to save the Euro ?
    If the IMF…..that international bunch of loan sharks……. is against something then I am for it…
    Down to 1.03 then upto 1.12 come on ….its a scam.
    As we say in Birmingham don’t tell me it’s raining when you are pissing down my back.

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