British markets have been on edge for weeks, as uncertainty over the new mini-budget put pressure on the Pound, and drove long-term interest rates higher, prompting the Bank of England to restart bond purchases. Liz Truss, the new PM, wanted to stimulate the economy by cutting taxes and regulations, but markets did not regard that as a positive sign for fundamentals.
In the absence of central banks’ intervention and due to elevated inflation, expansive fiscal policies can exacerbate problems. Even if painful in the short-term, conservative spending is what can reestablish equilibrium. That lesson has certainly been learned by the UK government, albeit the hard way.
Increasing fiscal spending at a time when interest rates rise
Inflation is a global phenomenon in 2022 and Britain stands at the forefront because people don’t often see a developed economy printing double-digit price rise figures. Inflation is already at levels not seen in 40 years, exceeding 10% based on the latest releases.
These developments require the central bank to step in by raising short-term interest rates and unwinding asset purchases. Both measures lead to tightening financial conditions, meaning the monetary supply will start to decrease.
When the government wants to spend on a deficit, financing the debt might be difficult as private markets ask for higher yields. That’s exactly what happened in the UK – yields rose, exacerbated by pension funds which also had to trim their bond exposure.
BoE forced to intervene
The currency exchange rate acts as a release valve during such a crisis and based on the quotes provided by easymarkets.com, GBPUSD fell to around 1.04 before managing to find a bottom. Currency weakness is another fuel for inflation, which is why financial markets began to price in more aggressive BoE rate hikes.
Politically, the new government suffered a loss of confidence, with Conservatives now trailing way below Labour in polls. Ultimately, the Chancellor was sacked and with a different person in charge of the country’s finances, things started to improve, at least in the short-term.
Fiscal U-turn welcomed by the markets
Jeremy Hunt is the new UK Chancellor and his vision looks similar to what Rishi Sunak proposed. Immediately after being assigned the job, he announced an impressive U-turn on fiscal spending, basically reducing the mini-budget almost completely.
Financial markets reacted positively to the news and at the time of writing, GBPUSD has managed to recover, trading around 1.13. Pressure on long-term yields has diminished, despite the fact that the BoE ended the short-term bond-buying program.
The new all-time high against the US Dollar is a negative development for the Pound and despite the current bounce, there is a long-term bearish trend in place. Moving forward, the market will focus on inflation dynamics, BoE measures, fiscal spending, and economic activity, in order to assess whether the currency will or will not fall further. All of these show that the era of low interest rates and runaway deficit spending is over, and that governments are looking to temper inflation and reestablish credibility.
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