Liz Truss’s tax gamble sends British pound plummeting to new low

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British Prime Minister Liz Truss has only been in charge for a few weeks but she has already managed to spook financial markets, drive the value of the British pound down to levels never seen before and prompt the Bank of England to issue a rare statement to calm investors.

Sterling’s value fell to a record low against the U.S. dollar on Monday – with £1 buying US$1.03 – and some analysts said it could hit parity with the dollar by November. The currency recovered to US$1.06 by mid-afternoon, but that was still the lowest level since the mid-1980s and down 20 per cent this year.

The pound’s fluctuation reflected growing angst among investors over Ms. Truss’s economic policies and her apparent fixation with slashing taxes and increasing government borrowing.

Ms. Truss won the race to succeed Boris Johnson as leader of the Conservative Party, and prime minister, on Sept. 5. She ran on a free-enterprise platform that focused on lowering taxes and reducing the role of government. After a 10-day pause because of the death of the Queen on Sept. 8, Ms. Truss and Kwasi Kwarteng, the new Chancellor of the Exchequer, have come out swinging.

The British pound has taken a tumble. What’s the impact?

Last Friday, Mr. Kwarteng unveiled a mini-budget that included the biggest tax cuts in 50 years. Among the measures announced were plans to lower the top tax rate to 40 per cent from 45 per cent, scrap a planned increase in corporate tax and eliminate a cap on bonuses paid to bank executives. And over the weekend, Mr. Kwarteng signalled that the government will go even further in a coming budget.

Mr. Kwarteng and Ms. Truss said the measures would spur economic growth and free up businesses to expand. They have yet to spell out in detail how to pay for everything, but government borrowing is expected to climb by as much as £100-billion ($147-billion).

The scale of Friday’s announcement and the level of borrowing have roiled financial markets. On Friday, the pound sank 3 per cent in value against the U.S. dollar, the biggest single-day drop in two years.

The government’s moves have also raised fears that the tax cuts could fuel inflation, which is already close to 10 per cent.

Ever-rising prices could prompt the Bank of England to raise interest rates further. Last week, the bank increased rates from 1.75 per cent to 2.25 per cent, the highest level for 14 years. Financial markets signalled on Monday that currency traders expect rates to climb to 4 per cent in November and 6 per cent by next summer.

The dilemma for Ms. Truss is that while she is eager to boost economic growth, the Bank of England is trying to put the brakes on inflation by cooling the economy.

“The market’s continuing verdict on the mini-budget, which turned out to be anything but mini, couldn’t really have been any more savage,” said Russ Mould, director of London-based brokerage AJ Bell. “The spectre of parity against the [U.S.] dollar, which felt far off just a week ago, now feels dangerously close.”

Paul Donovan, an analyst at UBS Investors, said the wild swings in bond prices and sterling’s valuation should remind investors that “modern politics produces parties that are more extreme than either the voter or the investor consensus. Investors seem inclined to regard the U.K. Conservative Party as a doomsday cult.”

In a statement late Monday, the Treasury Department sought to reassure investors by saying that Mr. Kwarteng would provide details on Nov. 23 about how the government intends to finance its policies.

“The fiscal plan will set out further details on the government’s fiscal rules, including ensuring that debt falls as a share of GDP in the medium-term,” the department said. It added that the Office for Budget Responsibility (OBR), a government financial watchdog, will provide an analysis of the spending and borrowing plans. Mr. Kwarteng has faced criticism that the OBR was not asked to provide an analysis of last week’s mini-budget.

The Bank of England also issued a statement to say that it was “monitoring developments in financial markets very closely in light of the significant repricing of financial assets.”

Many investors were calling on the central bank to intervene with an emergency rate hike on Monday to help boost the value of the pound. That didn’t happen and instead the bank said that it would address the situation at its next scheduled meeting in November. It also added that it would “not hesitate to change interest rates by as much as needed” to control inflation.

The two statements did little to ease the pressure on the pound and it quickly fell back to US$1.06 after rising as high as US$1.08 on Monday.

The volatility became so intense by the end of the day that some lenders temporarily withdrew mortgage products for new customers. “Following a number of changes in the market, we have made the decision to temporarily withdraw all our products for new customers at 8 p.m. tonight,” Virgin Money said in an e-mail to brokers.

“The procyclical mini-budget is seen as counterintuitive to international investors in the U.K. who must be wondering if politicians understand the ramifications of policies which have triggered a meaningful sterling crisis,” said Alastair George, chief investment strategist at Edison Group, a London-based brokerage.