Pound plunges after new British government releases budget

The newly formed UK government rolled out its fiscal plans Friday morning – and the response from global financial markets has been beyond stunning.

Why it matters: Essentially, the markets treat the UK in the same way as emerging markets, which are seen as not having the same reliable, disciplined economic policy-making institutions as the richest countries.

  • Aside from the unique crises Britain is currently facing, we find ourselves in an upside-down world compared to the 2009-2019 period. Policymakers around the world will want to note that shortages can matter again, even in wealthy countries.

Send the news: The government led by Prime Minister Liz Truss announced a budget, including extensive tax cuts, along with help for Britons facing skyrocketing energy bills this winter.

  • The package was larger than analysts expected and amounted to about 1.4% of UK GDP, according to JPMorgan. By comparison, the additional spending included in the Biden administration’s signature climate and health care package next year is expected to exceed 0.14% of US GDP.
  • The prospect of higher deficits led to rising UK bond yields, with the five-year yield rising almost half a percentage point to 4.02%. According to Bloomberg, it was the largest one-day move ever.
  • That coincided with the pound’s decline in foreign exchange markets to $1.09 at 11:55 a.m. EDT, its lowest level against the dollar since 1985.

Between the lines: Normally, when leaders of an advanced country like Britain lean towards more expansionary fiscal policies, the effect is higher interest rates, but also a rising currency as investors try to take advantage of the rising growth and those higher rates.

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  • That’s what happened, for example, after former President Donald Trump’s surprise victory in the 2016 election. Feeling that the US would cut taxes — leading to wider deficits — under his leadership led to a 6% rise in the dollar index in the following weeks.
  • That pattern we’re seeing in Britain – of higher rates and a weaker currency – is what you would expect to see in countries where investors don’t trust governance institutions to prevent deficits from spiraling out of control and fear that the value of their bonds will fall. bloated, or worse.
  • This will put pressure on the Bank of England to raise interest rates even further than planned, as fiscal stimulus and the weaker pound will exacerbate inflation. However, that also makes a recession more likely.

In the meantime: Decisions by the new government to fire the UK Treasury’s top official and release this budget plan without the traditional IRS review also add to a sense that economic policy making in the world’s seventh largest went wrong. economy.

What they say: The UK government “continues with extraordinary, even reckless ambition” in its fiscal policy, Evercore ISI’s Krishna Guha and Peter Williams wrote in a customer note.

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  • “[I]It is conducting a very high stakes experiment on where binding fiscal market constraints lie for a developed economy with its own central bank, large domestic financial system and domestic currency debt.”

Looking back: Around 2010, there was much discussion about ‘bond market vigilantes’, the supposed role that financial markets play in punishing any country that failed to demonstrate sufficient fiscal rectitude.

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  • It kind of became a punch line, and in hindsight, this wasn’t the right lens to apply to a country like the United States at a time of under-production and under-inflation. But now we see what bond vigilanteism really looks like in Britain.
  • It reminds us that the economic conditions of that time were really the opposite of today. The problem then was insufficient global demand; now it is one of insufficient global supply.

It comes down to: The era of policymakers having a free lunch when considering policies to stimulate their economy is over, as the bond and currency markets are telling the UK government loud and clear.

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