British pound, bonds tumble as tax cut plans spook investors

LONDON – A sell-off in British financial markets accelerated on investor concerns that the country’s biggest tax cuts in decades would trigger higher inflation and put government finances at risk.

The British pound briefly dipped to an all-time low against the US dollar on Monday before paring losses. The currency hit $1.0349 in Asian hours, breaking through its previous record low set in 1985. It then reversed to just below $1.08, down a little less than 1%.

The pound’s fall followed a 3% drop on Friday after the government announced a raft of tax cuts for businesses and individuals. It marked the currency’s biggest one-day drop since the start of the pandemic in 2020 and its second biggest drop since the 2016 vote to leave the European Union.

The price of UK government debt also fell sharply again on Monday, pushing up interest rates. The 10-year Treasury yielded 4.11%, up 28 basis points.

The market turbulence looms as a major challenge for new British Prime Minister Liz Truss, whose government has made a sharp U-turn on economic policy compared to previous Conservative governments by unveiling plans aimed at kick-starting growth through both higher spending and taxes . cuts rather than focusing on financial stability.

The tax cuts will hit government revenues at a time when the government has also unveiled massive subsidies for consumers and businesses over the next two years to shield them from the worst of much higher energy prices due to the war in Ukraine. Overall, the size of the plan spooked markets at a time when inflation is already high and the Bank of England has raised interest rates quickly.

On Monday, the government suggested it would not heed some calls to drop some of its biggest planned tax cuts, including a drop in the top tax rate for Britain’s highest earners to 40% from 45%.

“I am always calm,” British Chancellor of the Exchequer Kwasi Kwarteng said on Monday. “Markets move all the time. It’s very important to stay calm and focus on the long-term strategy.”

If the pound continues to fall along with the price of UK government debt, the government’s plans to spur growth could be derailed, particularly if the moves prompt the central bank to implement an emergency rate hike to try to stabilize the currency or carry out a more aggressive hike during next scheduled meeting in November.

If the government does not back down on some of its plans, the central bank should raise interest rates aggressively by a full percentage point to 3.25% at its next meeting, according to Mohamed El-Erian, chief economic adviser at Allianz and president of Queens College, Cambridge.

If the British government doesn’t back down, it will be at odds with the central bank and pulling in opposite directions as the government spends more money and the bank makes it more expensive to borrow money, he told the British Broadcasting Corp.

Rising borrowing costs could increase mortgage repayments for millions of UK households.


Photo:

Dinendra Haria/Zuma Press

“Again, the image of driving the car with the chancellor, foot on the accelerator, and the governor, foot on the brake,” he told the broadcaster in an interview. “It’s not a good way to run the UK economy.”

Much of the investor concern is not necessarily about whether the UK government will service its debt, but rather a perception that the tax cuts will spur higher interest rates down the road, slowing much of the economic growth the new government hopes to achieve. , said Kallum Pickering, senior economist at Berenberg bank.

“The widespread interpretation that rising gilt rates reflect market concerns about the UK’s debt sustainability is, in my view, wrong. More likely, the rise reflects and is proportional to the expected economic costs of the fiscal package – namely higher inflation and a steeper Bank of England… bank rate path, ” Mr. Pickering wrote in a note to clients on Monday.

Given that interest rates charged across much of the UK mortgage market are variable, rising borrowing costs could lead to mortgage payments for millions of households across the country, potentially canceling out some of the relief from lower tax rates and the energy savings .

Ms Truss and Mr Kwarteng have said the UK economy is stuck in a vicious cycle where slow economic growth produces less revenue for the government, forcing it to raise taxes to pay for public services, which in turn further slows growth.

Mrs Truss’ plans for tax cuts put her at odds with her rival, Rishi Sunak, in the Conservative leadership contest to replace Boris Johnson in the summer. Mr. Sunak, the former chancellor, said that cutting taxes at a time of high inflation was too risky and that lower taxes should be introduced after the economy has stabilized from the pandemic and the impact of higher energy prices.

Johnson’s government raised spending sharply, but also raised taxes. Previous Conservative governments led by Theresa May and David Cameron implemented spending cuts in an attempt to support UK finances without major tax increases.

In September, Liz Truss spoke after winning the Conservative Party’s contest to become Britain’s next prime minister as the country approaches an economic crisis. Her victory follows the resignation of Boris Johnson following a series of political scandals. Photo: Chris Ratcliffe/Bloomberg News

Write to Matthew Thomas at matthew.thomas@wsj.com and Max Colchester at max.colchester@wsj.com

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