The pound fell to its lowest point against the dollar, with bond yields skyrocketing, prompting an emergency intervention by the Bank of England and a tax reversal by the UK prime minister.
The pound fell to its lowest point against the dollar, with bond yields skyrocketing, prompting an emergency intervention by the Bank of England and a tax reversal by the UK prime minister.
the story So Far: On Monday, 3 October, the recently elected Prime Minister of the United Kingdom, Liz Truss, was forced to reverse a plan to bring Britain’s biggest tax cuts in 50 years after a “minibudget” presented by her Finance Minister Quasi Quarteng was. country market. Announcing the reversal and acknowledging that the budget plan had become a “distraction” from the new government’s mission to “tackle the challenges” facing the UK, Mr Quarteng said: “We get it, and we have listened. have taken.”
Notably, the International Monetary Fund (IMF) last week slammed the government’s new tax plans, warning they could exacerbate inequality and drive inflation. The most immediate response to the plans was to cause the pound to fall to record highs and increase the government’s borrowing costs to record highs, prompting an emergency intervention by the Bank of England.
Monday’s tax cut announcement helped the pound sterling to bounce back against the dollar. It was up 1.4% from the highest level before the announcement of the minibudget.
What was the announcement in the mini budget and what happened after that?
United Kingdom tax cut: biggest in 50 years, Source: Sankalp Foundation
On 23 September, the UK Chancellor of the Exchequer Quasi Quarteng in a “minibudget” statement announced the country’s biggest tax cut in 50 years, worth £45 billion ($48.7 billion; with €50.3 billion). -with additional massive spending to “spur economic growth and increase revenue”. This was in addition to previously announced plans of more than £60 billion to cap rising energy bills for homes and businesses .
The problem, however, was that the announced plans were either unfinanced, or had to be financed by further borrowing. While governments typically announce tax cuts to boost the economy, they also announce cuts in government spending to ensure that borrowing does not increase, but instead, Mr. Quarteng’s Plan called for huge extra expenditure filled with credit.
While inflation was already at record highs, the borrowing-heavy plan caused a crisis of confidence in the government, with markets and investors worried that the tax cut would drive inflation and prompt the Bank of England to raise its interest rates at a faster rate. will force. , Investor mistrust deepened as the UK budget watchdog Office of Budget Responsibility (OBR) did not accompany the plans for forecasting or evaluation. Furthermore, the British think-tank Resolution Foundation, in agreement with the IMF, also said that tax cuts would unjustly benefit the richest Britons.
After the mini-budget on September 23, the pound fell more than 3% and two days later, briefly returned as low as $1.0349 per US dollar to $1.0671. The British currency was trading at levels that were last seen in the early 1980s.
Sterling’s depreciation in the dollar further strengthened fears of inflation in a country that imports a large proportion of its fuel, food and other products, at a time when imported Russian gas had already driven consumer inflation to a higher level than it did in 1989. Extended from level to level.
While Britain had posted almost steady growth since 2008, the government’s plan to borrow more was expected to increase the budget deficit to 4.5% of GDP, and the debt burden to 101% of GDP by 2030. had risen to One Bloomberg Economics analysis.
Therefore, while large economies are generally relied upon by investors for their ability to repay debt, analysts noted that due to radical tax plans to boost demand rather than supply, the market is no longer considered the UK as an emerging economy. Kind of believed. This meant a sharp increase in the country’s borrowing costs.
Countries borrow money through the issuance and sale of bonds (or gilts, as they are called in the UK), which are debt instruments with different periods of maturity. In the case of bonds, their price is usually inversely proportional to the interest rates charged on them.
In reaction to the policy, the British bond market opened on 26 September – prices plummeted, leading to the biggest sale of gilts in decades. Subsequently, bond yields (the interest charged by the government on borrowings) skyrocketed.
What caused the Bank of England to step in?
On 28 September, against the backdrop of the sterling and bond market crises, the Bank of England (BOE) launched an emergency intervention, announcing that it would sell close to £65 billion ($69 billion) of the government’s longstanding bonds. will purchase. , Incidentally, it came at a time when the BoE was set for a phased sale of 838 billion pounds ($891 billion) to reduce its government bond holdings.
The bank said its emergency bond purchase was to prevent potential risks to the stability of the country’s financial system and, more importantly, to mitigate the impact on Britain’s large pension funds, which together hold nearly $2 trillion. Dollar assets. Reuters.
UK pension funds invest in bonds to build wealth, and a large proportion of these pension funds follow a strategy called liability-driven investing (LDI), in which essentially the same amount of assets is invested as future liabilities. To protect the schemes from the risk of swing markets. ,
Therefore, when gilt prices fell and yields rose, the pension fund’s assets began to lose value. This meant that the fund was getting margin calls by LDI managers to immediately raise collateral to offset liabilities and avoid collapse. As a result, pension funds quickly began to sell their gilts to raise cash, leading to a further drop in gilt prices, in what some analysts described as a “doom loop”. Hence, the BoE’s emergency bond-buying intervention to stabilize bond prices and lower yields to shield the financial system and pension funds.
How do analysts react to the tax plans? Is the crisis over?
Aside from the pound’s rise, it remains to be seen how Truss’s U-turn on tax plans helps stabilize the market.
As long as they remained in their place, the outlook seemed grim. While yields or interest rates on bonds fell below 4% for some time after the BoE intervention, indicating some relief, they rose again the next day. The bank plans to buy $69 billion worth of bonds through daily auctions by October 14. Analysts said that although this was enough to calm the waters in the short term, if Mr. Quarteng’s tax plans are not reversed, the market could become volatile again when the temporary intervention ends.
Both Ms Truss and Mr Quarteng did not initially indicate a change in plans. bloomberg London’s top bankers last week urged East to reassure the market and not wait for their planned statement on 23 November, the report said.
A BoE executive also warned that inflationary pressures would increase if the tax cut schemes are implemented, forcing the bank to significantly increase interest rates for borrowers to curb spending. Will go
This meant that the crisis would not stop on the financial markets, but was also expected to have a cascading effect on the housing market. David Blanchflower, former member of the BoE’s Monetary Policy Committee dw That enormous volatility in the system “will lead to the collapse of the housing market because interest rates are going to go up, people can’t get mortgages and the price of those mortgages is going up”.
“It looks like the UK is in great turmoil, heading into recession. It looks like a completely incompetent economic policy by a prime minister, which has been three weeks,” he said.
bloomberg Berenberg Bank senior economist Kallum Pickering is quoted as saying that the BoE’s intervention had bought “government time to recover its credibility”.
“As the UK has damaged its once strong credibility with a poorly managed Brexit and persistent threats of a UK-EU trade war, it no longer gets the benefit of the doubt.” They said.