by NGOC ANH 30/09/2022, 11:07

Will the Sterling fall much further?

Following the UK government's announcement of unfunded tax cuts, the value of the pound against the dollar plunged to a historic low.

The Sterling fell to a record low against the US dollar, after the UK government announced unfunded tax cuts.

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Whether you would describe the furore surrounding UK Chancellor Kwarteng’s ill-judged mini budget as a true crisis is hard to say. Sterling has fallen sharply, but the currency is not part of a fixed or semi-fixed exchange rate mechanism, and UK debt is not predominantly issued in foreign currency. Hence, the two attributes that can really mark a true crisis are absent in the UK. But this does not rule out the probability that things could still get very difficult for the government, the Bank of England - and the holders of UK assets.

Crisis-like situations can occur for many reasons, such as an adverse shock or a policy mistake. The UK has had both: the twin COVID-19 and Ukraine shocks, and now what seems to most to be a big policy mistake by the government in the shape of its mini budget.

Most other countries around the world have had the same adverse shocks as the UK, but few have seen such a policy mistake (Turkey springs to mind). If a policy mistake is the true reason for the plunge in sterling and gilt prices, then it is most clearly remedied by reversing the policy. But it is not at all clear that this will happen (although we think it might in the end). If we assume that the government stubbornly sticks to its fiscal splurge, how will this play out in the markets and how will policymakers have to respond?

We have seen some things happen already, what with the BoE’s comments that hint at a big base rate rise next time. The government has also attempted to reassure citizens by stating that its fiscal statement on November 23rd will demonstrate that it is serious about fiscal responsibility (and hopes that the independent Office for Budget Responsibility will support this in its own forecasts for the economy and budget finances). The first stage of any crisis response is such words of reassurance. But the bank has already had to go beyond this with a commitment to buy longer-term gilts in daily auctions up to October 14th, although this can be extended if necessary.

>> UK's inflation pressure and impacts on GBP

More interventions could be needed depending on how financial markets move. Credit default swaps (CDS) are another market to keep an eye on, in addition to sterling and gilts.A surge here would really show that the market dislikes the government’s fiscal plans and fears that they could result in some sort of budgetary crisis.

So far, CDS prices have moved sharply higher, with 5-year CDS prices up from around 28 bps before the fiscal announcement to around 45 bps now. And back in the summer, these prices were around the 10-bps level. Today’s levels are around those seen at the height of the COVID-19 pandemic but still some considerable way from the 175-bps area seen during the 2008 global financial crisis.

Unlike the gilt market, there’s little the Bank can do if CDS prices surge; instead, what will be required is a change of fiscal course by the government. Another area of focus will be funding. If the markets get nervy about a country, then funding costs can start to move higher outside of what we see for government funding costs via the gilt market.

For instance, dollar borrowing costs can rise, and that would be of significance for the UK given its strong financial sector; something that the Chancellor wants to strengthen, not weaken. So far, there’s been little sign of any pressures, with cross-currency basis swaps in sterling, for instance, still pretty static. Of course, if things get worse, we’d expect the Bank to use its dollar funding capabilities to try to ease the strain. What about the pound itself? Can policymakers’ do much to arrest the slide? Intervention will likely be futile, particularly as the Bank has relatively small FX reserves (USD86bn as opposed to the USD1.3tr that the BoJ has started to use to defend the yen).

Higher rates could help but given the tricky economic situation, the bank might prefer to avoid the sort of shock and awe hikes that could really set the sterling bears back. But even if it catches up with bigger rate hikes later, we fear that the market will still see this crisis-like situation as being generated by the government, and one the government will have to fix through an embarrassing policy reversal. If not, we fear the pound will fall much further.