When Kwasi Kwarteng announced last week that the UK government’s plan to abolish the 45% income tax rate in the UK had been shelved, the new chancellor of the exchequer did not just provide yet another reminder that a week – or to be precise, 10 days – is a long time in politics. He also relieved some of the pressure on a currency that had touched record lows.
We expect that the Fed won’t be able to go much further with tightening
John Hardy, Saxo
But with prime minister Liz Truss digging her heels in over the other tax cuts included in the UK’s recent mini-budget, sterling remains under intense pressure. JPMorgan reckons that in the absence of a change in government policy, interest rates will likely need to validate market pricing of 6% to preclude further pronounced weakness in GBP.
While the UK government’s decision not to consider any more tax cuts until a new budget in 2023 has given the market some short-term confidence, other policies to be announced in its new fiscal plan – which was originally planned for November 23 but is now expected to come sooner – could undo any hawkishness that the Bank of England (BoE) had planned, according to Charlotte Hampshire-Waugh, global head of trading payments and FX at StoneX Financial.
Not only has the BoE had to delay implementation of quantitative tightening, it was also forced to step into the market with a temporary backstop bid for long-dated gilts. The backstop runs from September 28 to October 14, and by October 5 had seen the bank buy some £3.7 billion of bonds out of the £10.4 billion offered to it. The move initially helped to bring yields down, although by the end of last week there were signs of weakness again.
Inflation response
In addition, the BoE must still move fast to tackle inflation and this is something it is not doing: the longer it waits and the longer the pound gets smashed, the bigger the required policy response. That is the view of Swissquote senior analyst Ipek Ozkardeskaya, who reckons markets may not have to wait until the next scheduled BoE monetary policy committee meeting on November 3 to see UK rates pushed higher.
“The Bank of England is now likely to go big in early November, more than we have seen from any other major central bank this year,” says Oanda senior market analyst Craig Erlam. “Markets are pricing in 125 basis points, highlighting the awkward position it has been left in. This may help steady the pound in the near term, but the economic outlook remains bleak and that may well take its toll regardless of what the bank does.”
The only solution is for the Bank of England to hike rates more aggressively
Adam Button, ForexLive
Longer-term restoration of confidence in the pound will likely require a more responsible message on fiscal prudence, as well as a higher BoE rate policy relative to global peers. But the BoE may not have to hike more than the market expects next year if Fed expectations decelerate soon.
“We expect that the Fed won’t be able to go much further with tightening because it will risk triggering a financial market systemic problem before the economy begins to suffer badly,” says John Hardy, head of FX strategy at Saxo.
A policy rate above 5.50% would be very painful for the UK economy, especially the housing market.
The shock to UK fiscal confidence will last for years and the fall in the pound will add to inflation, says Adam Button, chief currency analyst at ForexLive.
“The only solution is for the Bank of England to hike rates more aggressively,” he adds. “A 125 basis points increase in early November is a good starting point, but nothing has changed in the long term. There is a growing chance of a negative feedback loop on the GBP and gilt crisis and consumer/business spending, and if that unfolds as expected and the Fed stays hawkish, it is tough to envision a sustained bounce in sterling until the Fed pivots.”
Sterling is likely to slide further and at least revisit its recent record lows unless there is a substantial shift in the policy outlook and clear communication regarding it, according to Axel Rudolph, senior financial analyst at IG Group.
Since Brexit there has been a marked deterioration in the market’s perception of UK fundamentals
Axel Rudolph, IG Group
“Sterling has fared slightly better against the euro and yen than the dollar, but since Brexit there has been a marked deterioration in the market’s perception of UK fundamentals,” he says. “This is not just a function of the chancellor’s new expansionary fiscal policy stance, but also of the ongoing concerns regarding the UK adhering to the Northern Ireland protocol, a non-existent trade agreement with one of the world’s largest trading partners (the US), and the prolonged inflation shock, which the BoE has been struggling to contain.”
AvaTrade chief market analyst Naeem Aslam also reckons parity is still on the table when it comes to GBP/USD. “The current upward momentum – or shall we say a rally – is being questioned by many, with traders believing this is likely to end up in a dead-cat bounce,” he says.
Alex Kuptsikevich, senior market analyst at FXPro, takes a more optimistic view, though, suggesting that the technical view inclines his firm to expect a reversal of sterling’s fortunes.
“The Bank of England’s rescue of UK debt markets by announcing unlimited purchases of long-term government bonds on the balance sheet have almost brought back gilts yields, and with them, confidence in the pound,” he says, adding that a long decline accelerating to “absurd levels”, followed by capitulation and a long-term reversal of decline, is par for the course.
