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26 September 2022

Financial markets have rejected the Tories’ economic vandalism

The slide in sterling indicates that traders are cynical about Liz Truss’s big gamble on growth.

By Will Dunn

The big question for free-market libertarians such as Liz Truss and Kwasi Kwarteng is whether they can sustain their faith in the invisible hand of rational self-interest when it becomes, as it has this morning (26 September), a fist that is aimed in their direction.

While it was easy for Truss, in her single televised interview before taking over as Prime Minister, to denounce the BBC and “the media” as biased against her, she has no such defence against investors. The trading decisions in financial markets – almost all of which are made by machines – now concur that Truss and Kwarteng have embarked on a reckless and incoherent programme of economic vandalism.

The pound fell this morning to its lowest-ever level against the dollar, briefly reaching $1.037, while UK government bonds have sold off more quickly than they did during the 1992 sterling crisis or the global Covid-19 pandemic.

Future expectations for the pound can be read in the prices of options contracts, which are valued against the predicted price of an asset. On Friday 23 September, options markets suggested a 17 per cent chance that the pound would trade one-for-one with the dollar at some point this year; by this morning, that prediction had risen to 60 per cent.

A falling pound (and a strong dollar) is good for some, especially the large British multinationals that do a lot of business abroad. These companies can now offer services in the US at very competitive rates, and the dollars they earn are worth relatively more to them in the UK. Janet Mui, head of market analysis at Brewin Dolphin, pointed out to me that FTSE 100 companies make almost 27 per cent of their revenue in the US.

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But the opposite is true for importers, and by extension consumers. Truss, well known for her fascination with the international values of cheese and pig meat, will surely know that the UK imports 46 per cent of its food, most of which will be made more expensive by a fall in the purchasing power of the pound relative to the euro (even with Europe’s currency at its own 20-year low) and the dollar. Even domestically-produced food prices will be pushed up by the cost of the dollar-denominated commodities – such as oil – used in production.

The main indicators of the government’s cost of borrowing – the yields on five- and ten-year government bonds – also continued to grow this morning, with the yield on five-year gilts rising to over 4.5 per cent, its highest since the darkest days of the financial crisis in October 2008. Mui said that Kwarteng’s suggestion on Sunday (25 September) that even more tax cuts were under consideration could have led investors to conclude that the government’s vast borrowing had “put the UK on to a fiscally unsustainable path”.

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This means investors now expect interest rates in the UK to rise significantly, and remain elevated for a decade. Some expect that the Bank of England – which is not scheduled to decide on interest rates for more than five weeks – will convene an emergency meeting this week to raise rates decisively, with the hope of stabilising the currency. Investors are now pricing in an interest rate of over 6 per cent in the first half of next year.

[See also: How the pound has plummeted against the dollar]

Financial markets had already priced in an assumption that higher inflation and higher interest rates would be the price of the government’s strategy to finance its energy plan through a huge programme of borrowing rather than a windfall tax on energy companies. The tax breaks announced on Friday – which one expert priced at £169bn over five years – added even more to this bill. The Treasury itself predicted £72.4bn of new borrowing in the next year alone.

Investors reward risk – speculation is in one sense a game to see who can take on the most risk – but only if they think it will pay off. The ongoing market reaction to Friday’s fiscal event suggests a widespread acknowledgement that the government is not going to produce the very significant GDP growth it will need to pay for all this new debt through the policies it has announced. Businesses will face soaring borrowing costs as rates rise and stay high; imports will become more expensive in a country with a huge trade deficit; and the small group of consumers who will benefit from tax cuts are wealthy people who already have considerable savings and are unlikely to unleash much demand.

In fact, well over a million people will find themselves paying more tax, thanks to frozen income tax thresholds, something that will lead to still lower confidence in a country already burdened by high levels of consumer and business debt and a dangerously unaffordable housing market. If the Bank is forced to raise rates as much as markets predict, the effect on the personal finances of almost everyone in the UK could be seismic.

[See also: Is Liz Truss trying to lose the next election?]