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Edward Bell - Senior Director, Market Economics
Published Date: 26 September 2022
Sterling has collapsed in response to plans from the British government to ease taxes without any parallel move to lower spending. An initial response on September 23rd saw GBPUSD fall 3.6% in a single day to 1.0859 before opening this week even worse, with the pair falling briefly to a record low of 1.035, its lowest level since the UK adopted decimalization of its currency in the early 1970s.
Kwasi Kwarteng, the new British chancellor of the exchequer, outlined a broad change to the UK’s tax regime, scrapping the top level of 45% income tax on high-income earners, lowering the lowest band of income to 19% from 20% and also reversing planned increases in national insurance, a payroll tax, and a planned increase in corporate tax from 19% to 25%. The government has also raised the threshold at which stamp duty, a tax on property purchases, takes effect. Over the weekend the chancellor also said that there was “more to come” in terms of tax cuts, all ostensibly meant to improve growth by prompting more spending by households and businesses.
Source: Bloomberg, Emirates NBD Research. Note: 2022 level as of September 26 2022.
Markets firmly rejected the plans with the collapse in sterling the most notable move but borrowing costs for the British government also surged. The 2yr gilt yield jumped 44bps at the end of last week to 3.983% while the 5yr gilt yield spiked more than 50bps to 4.043% and the 10yr added 33bps to 3.82%. Should the government announce even more accommodative fiscal policy the sell off in British assets, particularly the pound and gilts could unwind in an even more disorderly manner.
The Bank of England had hiked rates by 50bps at its last MPC meeting on September 22nd and will be forced to do even more as the UK was already struggling with enormously elevated inflation. Markets have priced in a 75bps hike at the November MPC meeting, in a move to not just push back against inflation but also support the pound. One of the government’s new measures—its plan to cap utility costs—may actually help to keep short-term inflation from hitting some of the more calamitous forecasts in the market. But by limiting what consumers have to pay, the UK government will expose itself to any upside liability as it has no control on where wholesale energy costs will go. The government’s tax cut and energy cap plans may end up keeping inflation sticky in the UK by notionally allowing consumption to remain steady.
In the near term, more pain may be in store for GBPUSD. Short positions against sterling futures have increased as investors take a grim view of the economy. With the Bank of England still seeming to show a lack of unanimity on what steps to take, investors may pile more pressure on sterling: the MPC split its vote for the 50bps hike last week with five members supporting, three voting for a 75bps hike and one voting for a 25bps move. That compares with a unanimous decision from the Federal Reserve for a 75bps hike at its latest FOMC meeting. The BoE may also choose to step in with an emergency meeting though that could end up worsening the hysteria around sterling as it may be interpreted as the central bank panicking.
Moreover, GBPUSD still doesn’t appear to have fallen that far on a real effective exchange rate basis. Unlike the Japanese Yen or Euro which have also seen wide depreciations against the US dollar, the pound has potentially some way to go before it allows for any snap back in performance.
Source: Bloomberg, Emirates NBD Research.
With the risk of more near-term disorder our already negative view on GBPUSD is looking too optimistic. We now expect that GBPUSD will hit parity by Q4 this year. For 2023 we are adjusting our expectations lower given that more downside may be ahead for the economy with a Q1 target for GBPUSD at 1.03, Q2 at 1.05 and then an improvement to 1.08 for Q3 and 1.10 by the end of next year.
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