A week ago, the Bank of England took a stab in the dark. It raised interest rates by a relatively modest half a percentage point to tackle inflation. It couldn’t know the scale of the storm that was about to break.
Less than 24 hours later, the government of new UK Prime Minister Liz Truss unveiled its plan for the biggest tax cuts in 50 years, going all out for economic growth but blowing a huge hole in the nation’s finances and its credibility with investors.
The pound crashed to a record low against the US dollar on Monday after UK finance minister Kwasi Kwarteng doubled-down on his bet by hinting at more tax cuts to come without explaining how to pay for them. Bond prices collapsed, sending borrowing costs soaring, sparking mayhem in the mortgage market and pushing pension funds to the brink of insolvency.
Financial markets were already in a febrile state because of the rising risk of a global recession and the gyrations caused by three outsized rate increases from a US central bank on the warpath against inflation. Into that “pressure cooker” stumbled the new UK government.
“You need to have strong, credible policies, and any policy missteps are punished,” said Chris Turner, global head of markets at ING.
After verbal assurances by the UK Treasury and Bank of England failed to calm the panic — and the International Monetary Fund delivered a rare rebuke — the UK central bank pulled out its bazooka, saying Wednesday it would print £65 billion ($70 billion) to buy government bonds between now and October 14 — essentially protecting the economy from the fallout of the Truss’ growth plan.
“While this is welcome, the fact that it needed to be done in the first place shows that the UK markets are in a perilous position,” said Paul Dales, chief UK economist at Capital Economics, commenting on the bank’s intervention.
The emergency first aid stopped the bleeding. Bond prices recovered sharply and the pound steadied Wednesday against the dollar. But the wound hasn’t healed.
The pound tumbled 1%, falling back below $1.08 early Thursday. UK government bonds were under pressure again, with the yield on 10-year debt climbing to 4.16%. UK stocks fell 2%.
“It wouldn’t be a huge surprise if another problem in the financial markets popped up before long,” Dales added.
The next few weeks will be critical. Mohamed El-Erian, who once helped run the world’s biggest bond fund and now advises Allianz
(ALIZF), said that the central bank had bought some time but would need to act again quickly to restore stability.
“The Band-Aid may stop the bleeding, but the infection and the bleeding will get worse if they do not do more,” he told CNN’s Julia Chatterley.
The Bank of England should announce an emergency rate hike of a full percentage point before its next scheduled meeting on November 3. The …