Is Sterling doomed?
Kwasi Kwarteng’s ‘budget in all but name’ has not been received warmly in financial markets. The energy price cap scheme likely means we’ve avoided a near term recession but the cost in terms of extra government borrowing is huge, with the Chancellor doubling down with tax cuts that raised borrowing even further. Just how far is anybody’s guess as he prevented the Office for Budget Responsibility (OBR) from working out the numbers properly. My guess is that the OBR would have forecast even bigger budget deficits. For example, the direct cost of the higher rate tax cuts is £6bn but the new Chancellor has assumed that ‘behavioural changes’ would reduce that to £2bn. This seems unlikely.
Sterling has hit at an all-time low and base rates are now expected to exceed 6%. Government bond yields have jumped. A similar profile can be seen around the world: central banks are raising rates faster than markets expect and bond yields are rising. But interest rate expectations in the UK have jumped in relative terms because of the new UK government’s measures.
Why is Sterling vulnerable?
So where do we go from here? Sterling is especially vulnerable because we have a huge current account deficit. As Mark Carney once said ‘the UK is dependent on the kindness of strangers’ as we need to borrow from abroad to finance the deficit – and that’s becoming increasingly expensive. That is part of the reason, but not the only reason, why the deficit reached a record in the first three months of the year. We get new numbers on Friday and the consensus is that it will improve but the truth is that we don’t really have any idea. They government statisticians have changed the way they calculate the numbers and aren’t sure if they’ve got it right. But the bigger picture appears very challenging.
The willingness of ‘strangers’ to bail us out is heavily dependent on global risk appetite. When equities are rising, Sterling tends to strengthen. Last week equities were very weak which was terrible timing for Kwasi Kwarteng’s fiscal event.
Can the Bank of England steady the ship?
Several members of the Monetary Policy Committee are due to speak this week and they will surely be hawkish. Government briefings tried to blame sterling’s fall on the MPC’s decision to hike base rates by ‘only 0.5%’ which seems somewhat strange. The Bank of England is independent, but the government effectively appoints the members and although they cannot fire Governor Andy Bailey in strict legal terms, he would almost certainly resign if the Chancellor so wished. Many expect Mr Bailey to be out of office early next year. I hope not.
Meanwhile, the rating agencies will be considering whether to put the UK on negative watch. But the Governor is but one member of the MPC and many other members of the committee would be happy to face down the government and raise rates aggressively. There is talk of an emergency meeting to raise base rates before the next scheduled gathering on 3rd November but if I was on the committee, I’d be against that – it’d look like a sign of panic. Instead, I would argue the case for a rise in rates to 5% over the next few months. That level would attract funds into the UK, but the new UK government does need some luck to avoid a financial crisis.
Parity with dollar looks likely
Sterling is rallying (at the time of writing) but it might well fall through parity versus the dollar over the next few weeks. Higher interest rates are needed to offset the increased risk from the new Chancellor’s measures and whilst the energy price cap may have averted recession this winter, the UK economy still looks distinctly vulnerable.