UK government bonds sold off sharply and the pound hit a new 37-year low against the dollar as investors worried that Kwasi Kwarteng’s tax cuts and energy subsidies would place Britain on an “unstable” fiscal trajectory.
The 10-year gilt yield surged 0.27 percentage points on Friday to 3.77 per cent, bringing its rise for the week to more than half a percentage point. This week’s rise marks one of the biggest increases in long-term borrowing costs on record. Sterling fell on Friday below $1.11 for the first time since 1985, while the FTSE 100 share index slid 2.4 per cent.
Friday’s heavy selling in gilts and the pound came after Kwarteng, the chancellor said the government would scrap the 45p top rate of income tax, replacing it with a 40p rate. He also announced a cut in stamp duty on home sales.
The tax cuts, which will reduce government income, come as the UK is expected to spend £150bn on subsidizing energy costs for consumers and businesses. Kwarteng said the energy rescue scheme would cost £60bn in its first six months.
A large swath of this borrowing will need to be financed by selling gilts. The UK Debt Management Office increased its planned bond sales for the 2022-23 fiscal year by £62.4bn to £193.9bn.
“This huge fiscal event is a radical economic gamble; a ‘go big or go home’ gamble that will put UK debt on an unstable footing,” said Bethany Payne, a bond portfolio manager at Janus Henderson Investors.
Investors are also anticipating more aggressive interest rate rises from the Bank of England to offset the inflationary impact of Kwarteng’s stimulus measures, following a 0.5 percentage point increase in the bank rate this week. The expectations for more aggressive BoE rate increases sent the two-year gilt yield soaring more than 0.8 percentage points this week.
Following the chancellor’s announcement, markets were pricing in 0.75 percentage point rises at each of the next three BoE meetings, taking rates to 4.5 per cent.
Adding to the pressure on UK government bonds, the BoE also announced on Thursday that it would next month begin selling gilts it holds as a result of previous bond-buying programs in an attempt to shrink its balance sheet.
Payne said that Friday’s borrowing announcements would make it even harder for investors to absorb BoE gilt sales, raising the possibility that so-called quantitative tightening “is over before it even began”.
The pound on Friday extended its recent tumble, slumping as much as 2.1 per cent after Kwarteng spoke, hitting a low of $1.1022, a level last seen in 1985, according to Refinitiv data. Against the euro, the pound fell 1.1 per cent.
“In this type of environment with the cost of living crisis, energy crisis. . . the chance for policy missteps rises,” said Stephen Gallo, head of European FX at BMO Capital Markets. “The currency is going to show a lot of the burden and it is doing that now.”
The combination of the rout in the gilt market and a fall in the pound — which should typically benefit from higher interest rates — sends a “worrying” signal that investors’ faith in UK economic policy could be ebbing, said Mike Riddell, a portfolio manager at Allianz Global Investors.
“Saying the UK is becoming an emerging market is still clearly a step too far — there are still strong institutions. But it’s a slippery slope,” he added. “The danger is that if the market decides you are going down the road of essentially running the wrong policy — launching a massive fiscal stimulus when you have double-digit inflation — you lose your credibility that’s been built up over decades.”
Additional reporting by Chris Flood