Written by Amanda Cooper and David Milliken
LONDON (Reuters) – Sterling fell to a record low against the dollar early on Monday and British bond prices collapsed as concerns mount over the new government’s fiscal plan, unleashing calls for an emergency rate hike from the Bank of England to restore confidence.
New Finance Minister Kwasi Quarting sent government bonds and the British pound into free fall on Friday with the so-called mini-budget designed to grow the economy by financing tax cuts with huge increases in government borrowing.
On Sunday, in an interview with the BBC, he listed his tax cuts and added: “There is more to come.”
With the resumption of trading in Asian markets on Monday, the pound fell by as much as 5% against the dollar to touch $1.0327, its weakest level ever, before paring most of the day’s losses in European trading.
In the gold market, the pressure was even more intense, with five-year bond prices on track for their second biggest daily drop since at least 1991, after only Friday’s historic slump.
The two-year yield reached its highest level since September 2008 at 4.573%, up a full percentage point in the last two trading days, as Prime Minister Liz Truss’ government lost credibility with investors.
Mohamed El-Erian, chief economic adviser at Allianz, said the central bank would have no choice but to raise interest rates if Truss and Quarting did not back down.
“Not a little, by 100 basis points, by a full one percentage point to try and stabilize the situation,” he told BBC Radio.
Interest rate swaps are in high chance of a big BoE rate hike over the next week, well before the next scheduled interest rate announcement on November 3, and we see the BoE key rate hit 4% by the end of the year, up from 2.25%.
Truss, Britain’s former foreign secretary, was elected prime minister earlier this month by a vote of 170,000 Conservative Party members – not the broader electorate – in the wake of an internal rebellion that ousted Boris Johnson from power.
She has largely outpaced her rivals for the top job by vowing to reignite economic growth through tax cuts and deregulation to end the largely stagnant real wage growth that has characterized her party’s 12 years in government.
Her pledge to end so-called “Treasury orthodoxy” and move forward with growth marked a change of heart in British fiscal policy, harking back to Thatcher and Reaganomics doctrines of the 1980s.
Truss’ policy also contrasts with recent efforts by former advisors such as George Osborne to balance the books.
Kwarteng, a specialist economic historian at the end of the 17th century when the pound sterling was devalued, declined to comment on the market’s backlash. A person close to the finance minister said he was not affected by the events.
“Markets go up and down,” said a veteran Tory source, who asked not to be named. “We’ve done something that is structural in the short term that will have seismic and positive long-term benefits.”
However, the scale of the market turmoil began to worry some in the party, with one lawmaker saying those who were less ideologically close to Truss were “so worried,” that voters emailed them to express concern. The deputy asked not to be named.
Rachel Reeves, a former Bank of England (BoE) economist who is now the opposition Labor Party’s chief financial policy officer, said she was “deeply concerned” by the reaction.
Investors and analysts were more direct.
“The British decided that going back to the ’80s on steroids was the best way to go, and obviously the market is just saying ‘It’s not going to work,'” said Michael Evry, Rabobank strategist.
“The market is now treating the UK as if it were an emerging market. They are not wrong about the policy response and the naivety of thinking that boosting demand rather than supply is how to deal with a supply side shock.”
The pound rebounded to $1.0850 as of 1334 GMT, which left it almost flat during the day, but there was no recovery in gold bonds.
A Truss spokesperson declined to comment.
UBS’ Paul Donovan said investors appeared to be “inclined to view the UK’s Conservative Party as a doomsday cult”.
Some economists have warned that an emergency rate hike would lead to more panic. “I think this will increase the sense of tension and panic rather than calm it,” Andrew Sentence, a former policymaker at the Bank of England, told Sky News.
Further highlighting the extent to which investors are penalizing UK assets, the difference in 10-year borrowing costs for the British and German governments has exploded to the widest extent since 1992, when Britain exited the European Exchange Rate Mechanism.
UK 10-year government bond prices are now heading for their biggest drop in any calendar month since at least 1957, according to a Reuters analysis of Refinitiv and Bank of England data.
In response to that statistic, Paul Johnson, president of the Institute for Fiscal Studies, attacked the government’s decision to ignore the usual rules. “This will cost billions,” he said on Twitter (NYSE). “The economic and financial constraints are real. It’s not just ‘Treasury orthodoxy’.”