Traders bet on emergency rate hike after pound hits record low

Traders bet on emergency rate hike after pound hits record low
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The pound fell to a record low on Monday, while government bonds suffered heavy losses, fueling expectations of an emergency hike in UK interest rates after Chancellor Kwasi Kwarteng’s tax cut package last week.

The currency slipped as much as 4.7 percent, trading as low as $1.035 in the early morning before stabilizing around $1.07 after Kwarteng vowed to stick to its tax cut initiative over the weekend, sparking warnings that the UK was moving into a currency crisis occurs.

The early drop took the pound to its lowest level on record. It has compounded criticism of Friday’s financial statement, as the Chancellor announced a massive new wave of borrowing to support £45 billion in tax cuts and a package to curb rising energy bills finance.

“The UK is in the midst of a currency crisis,” said Vasileios Gkionakis, Citigroup’s EMEA head of foreign exchange strategy.

Traders increased their bets on an emergency rate hike to stabilize sterling ahead of the Bank of England’s next meeting in November. Futures markets are pricing in a 0.75 percentage point gain in a week and a more than 1.5 percentage point gain by the November meeting. Interest rates are expected to surpass 6 percent by May from the current level of 2.25 percent.

The central bank declined to comment on whether it plans an emergency interest rate meeting this week.

Reflecting the sharp shift in interest rate expectations, the UK government debt fell further on Monday after Friday’s sharp sell-off, the worst day for the gilt market since the early 1990s.

The price of 10-year gilts fell, pushing yields up a whopping 0.32 percentage points to 4.12 percent, from about 3.5 percent before Friday’s financial announcement.

The Treasury Department did not comment on market movements on Monday. Kwarteng said in an interview with the Financial Times last week: “I’m always calm. Markets are always moving. It is very important to stay calm and focus on the longer term strategy.”

But Mel Stride, Tory leader of the Treasury’s selection committee, criticized the Chancellor for signaling more tax cuts on Sunday.

“One thing is for sure – it would be wise to take stock of how markets are weighing recent economic announcements over time, rather than immediately signaling more of the same in the near term,” he said.

Meanwhile, Gerard Lyons, who advises Prime Minister Liz Truss’ new team on economic policy, said Kwarteng needed to do more to explain his approach to markets.

“He needs to reiterate that tax cuts are only part of the story, not the whole story,” Lyons said in an interview with Bloomberg Radio. “What they are pursuing is a supply-side agenda.”

He said the UK government should not change course and that the Bank of England should hike interest rates. “We have to get away from cheap money,” he said.

Line chart of $ per £ showing the pound sterling falling to a record low against the dollar

Unlike countries like Japan, which intervened last week, the UK lacks the resources and likely willingness to intervene directly in FX markets to support the pound. However, the BoE’s rate-setting monetary policy committee has met outside of the normal cycle when markets have historically been turbulent to restore calm, typically through rate cuts. Since becoming independent in 1997, the BoE has never hiked interest rates between scheduled meetings.

Sushil Wadhwani, asset manager and former BoE policymaker, said: “If I were still at the BoE, I would be tempted to announce an additional meeting in a week’s time.”

Westminster’s tax cuts come as the UK is expected to already spend £150bn to subsidize energy bills for consumers and businesses. Much of this borrowing is said to be financed by Gilts.

Contrary to the big tax cuts of the 1980s, Kwarteng is borrowing tens of billions of pounds to fund his plans, increasing demand while the BoE hikes interest rates to keep inflation under control.

“It looks like we are headed for a spiral that we typically see in emerging market crises, where policymakers struggle to restore credibility,” said Mansoor Mohi-uddin, chief economist at Bank of Singapore.

Mohi-uddin said investor confidence in sterling had been eroded by expectations that the UK government debt was now on an “unsustainable rising path” while the country still had a “jagging current account deficit”.

“If we continue to see these big moves in the market, the Bank of England will have to raise interest rates, maybe by as much as 1 percentage point, to try to stabilize the pound,” he added.

The Bank of England hiked interest rates by 0.5 percentage point on Thursday after the US Federal Reserve announced a third straight rate hike of 0.75 percentage point a day earlier.

“We had argued that sterling’s path forward would depend heavily on the short-term monetary response to inflation and targeted fiscal action, but so far performance on both fronts has been less than encouraging,” said FX analysts at Goldman Sachs.

“With broad unfunded spending on the fiscal side not being offset by monetary policy to offset the inflationary stimulus, the currency is likely to weaken further.”

Rachel Reeves, shadow chancellor, said Kwarteng “stoked the flames on Sunday by suggesting there might be more stimulus and more unfunded tax cuts.”

Reeves, a former Bank of England economist, said higher interest rates would worsen households’ cost of living.

“The Prime Minister and the Chancellor are like two gamblers in a casino chasing a losing streak. . . They’re not risking their money, they’re risking all our money,” she told BBC Radio 4’s Today Programme.

Labor has promised to reverse some of the tax cuts in Friday’s mini-budget – to Social Security, corporation tax and the scrapping of the 45p rate – but would keep the threatened cut in the basic income tax from 20p to 19p.

Additional reporting by Adam Samson in New York and Leo Lewis in Tokyo

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