The selloff in U.K. assets went into overdrive on Monday, sending the pound to an all-time low, slamming government bonds and sparking talk of emergency action by the Bank of England.
The market mayhem extended the damage seen on Friday in the wake of the government’s new fiscal measures, which sent investors into a panic. The plunge in U.K. gilts sent 10-year yields above 4% for the first time since 2010. Sterling dropped to as low as $1.0350, taking it closer to parity with the dollar, though it subsequently pared its loss to $1.07.
The latest tumble—fueled by Chancellor Kwasi Kwarteng’s comment on Sunday that there’s “more to come” on tax cuts—prompted calls for aggressive rate hikes from the Bank of England, with some urging emergency action as soon as this week.
It’s also led to talk of a currency crisis and is threatening to engulf Prime Minister Liz Truss’s days-old administration in turmoil as the country grapples with a cost-of-living crisis and a recession.
“The market remains very fragile and with the moves being driven by emotion it is very difficult to trade intraday,” said Antony Foster, head of G10 spot trading in EMEA at Nomura International Plc. “Parity for cable feels like a matter of time and while vols are off their highs there is no sense of relief in the price action this morning.”
Traders have ramped up bets on Bank of England rate increases, briefly pricing as much as 175 basis points of tightening by the next policy meeting in November. They see the key rate peaking at 6.25% by November 2023.
The swaps market is even pricing in a 25-basis point hike today, according to Alvin Tan, head of Asia currency strategy at RBC Capital Markets, citing bets implied from the FX forwards curve.
At Bloomberg Economics, economist Dan Hanson said currency’s drop “will set alarm bells ringing at the central bank.” If it’s sustained, he sees the Bank of England raising its benchmark by 100 basis points.
A Bank of England spokesperson declined to comment on the exchange-rate moves.
The Bank of England previously tried to prop up the pound on Black Wednesday, using rate hikes and currency purchases when sterling crashed out of the Exchange Rate Mechanism, a system linking a number of European currencies. That defense, which took place 30 years ago this month, ultimately failed.
“We think that the BOE is too psychologically scarred from the events of 1992 to try defensive currency-related rate hikes,” said Chris Turner at ING. “What happens if the BOE hikes 300-500 basis points and GBP/USD ends up trading lower?”
Another option is direct currency intervention, but it doesn’t have enough reserves for a meaningful, sustained action. One possible response to the bond market moves is for the BOE to delay a planned sale of the gilts it bought under quantitative easing. That process is due to begin next week.
On Monday, 10-year yields rose 31 basis points to 4.14%, and the 5-year jumped 45 basis points to 4.53%.
Domestic-focused U.K. stocks including homebuilders, retailers and banks also slumped. The FTSE 250 index fell 1.7% as of 11:10 a.m. local time, extending a year-to-date plunge to 25%.
Sterling’s early-hours slump marked its biggest intraday drop since March 2020, when the Covid-19 outbreak roiled markets worldwide. A CME Group spokesperson confirmed that the dramatic fall triggered a 2-minute pause in trading of front-month British Pound futures contracts at 2:01 a.m. U.K. time, after a circuit-breaker kicked in.
“It would be foolish to rule out parity,” said Dean Turner, U.K. economist at UBS Private Banking. “If the market’s got the bit between its teeth, then fair value, or valuations or fundamentals are going to count for very little.”
Gerard Lyons, an external adviser to Prime Minister Truss, acknowledged on Monday that the market had concerns about government policy. But he said that while Kwarteng should reassure investors, he shouldn’t reverse course.
“He needs to reaffirm that tax cuts are only part of the story, not the full story,” Lyons said on Bloomberg Radio. “What they’re following is a supply-side agenda.”
Options markets see a near-50% chance of the pound reaching dollar parity this year, up from 32% on Friday. Truss will face a rebellion from Tory backbenchers against her tax cuts if the pound hits that level, the Telegraph reported Saturday.
Meanwhile, the opposition Labour Party —already enjoying a comfortable lead in the polls—is seeking to capitalize on the policy gulf that’s opened up with the Tories at its annual conference, which began in Liverpool on Sunday.
Leader Keir Starmer told the BBC he’d reverse Kwarteng’s most eye-catching measure—the scrapping of the top 45% rate of income tax levied on earnings over £150,000.
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