Pound sterling plunges: the British currency is the cheapest in history (Daily analysis 26.09.2022)

British government bonds record their biggest ever discount, with the pound's exchange rate diving to historic lows. Investors are disastrously pricing in how the fiscal plans of the new UK Prime Minister and new Chancellor of the Exchequer could affect the country's economy.

Treasury securities have been plunging on global markets for months. Their sell-off intensified after last week's Federal Reserve meeting, which announced further strong interest rate rises in the US to suppress inflation. In such an environment, the announcements of a radical tax cut in the UK and the largest fiscal easing since 1972, to be financed by debt issuance, proved an impossible pill for investors to swallow. They have unambiguously reviewed how they view such a prospect.

Bank of England action cripples the pound

Prime Minister Liz Truss' cabinet's fiscal easing plans could have supported the pound. On one condition: they had to sound rational and inspire confidence, which means they could not shake the credit rating. At the same time, they were supposed to give hope of a boost to an economy where the outlook is bleak and convince the market that any moment now, they would become a trigger for more aggressive tightening by the Bank of England.

The UK monetary authorities started raising interest rates a few months before the Federal Reserve, but they are doing it rather reluctantly. So far, the cost of money in the UK has been pushed up to 2.25%, with individual increases not exceeding 50 basis points. More decisive moves have recently been made by the Fed, the European Central Bank, and the monetary authorities of Switzerland, Sweden and Canada, among others.

Instead of becoming a breather for the pound, which had been one of the weakest and most dollar-sensitive currencies for months, the demands made by new Chancellor of the Exchequer Kwasi Kwarteng on Friday proved to be the proverbial nail in the coffin of the British currency. The pound lost more than 3% against the dollar on Friday. The plunge in the British currency continued in the Asian session on Monday.

The pound has gone from a leader to a range of emerging market currencies

The GBP/USD exchange rate, which was around 1.35 at the start of the year, has collapsed below 1.04. This means that the GBP has been overvalued by more than 20% this year and is trading at a double-digit loss in September alone. There is massive volatility and chaos in the quotes, and the GBP sell-off bears the hallmarks of a gigantic panic. The British currency has gone from heaven to hell, as the UK was one of the strongest in developed economies last year thanks to a rapid vaccination drive and the unfreezing of the economy after the pandemic.

Today, some compare the pound to the most volatile emerging market currencies. One of the reasons for this is that the British economy is characterised by weak economic growth, high inflation close to double digits and deficits of several per cent: in the budget and in the current account with foreign countries.

Are tax cuts going too far?

The course taken by Liz Truss and Kwasi Kwarteng has been perceived as a straightforward way of exacerbating imbalances to weaken fragile fundamentals further. Tax cuts are expected to cost 160 billion GBP over five years. Almost a second as much by the end of 2024 could be consumed by a programme to mitigate the impact of rising energy prices on consumers and businesses. An astronomical 72 billion GBP increase in government borrowing needs has been announced for the 2022-2023 fiscal year. The UK relies on external funding due to low levels of domestic savings, with foreign investors holding around a third of the debt in their hands.

The increase in borrowing needs in the government's plan is far too sudden and the deterioration rate in the parameters of public finance health is too significant to outweigh concerns about the inevitable unsustainability in this area, especially since it beats wishful thinking, above all regarding the rate of economic growth, which is supposed to be 2.5%. With a weak economy in a time of energy crisis, fiscal stimulus may prove salvation, but it should be temporary, targeted at those most in need and designed to fuel inflation as little as possible. The intentions included the abolition of the 45% tax rate for the richest (those with incomes of more than 150,000 GBP a year), the reduction of the basic rate of PIT from 20 to 19% and the abandonment of the planned increase in CIT from 19 to 25% from April, definitely do not meet these criteria. Adding fuel to the fire is the UK Chancellor of the Exchequer himself. Kwasi Kwarteng announced on Sunday that this is not the end of the revolution in fiscal policy.

The pound's crash, combined with investors' concern that Italy's most right-wing government in the country's post-war history will be formed after this weekend's elections, is fuelling risk aversion. In the case of the British currency, there may be no escape from action on the part of the Bank of England, which may opt for extraordinary interest rate rises or currency intervention.