The quids aren’t alright – how the UK budget led to a collapse in the pound

Jeremy Stretch: And the markets were slightly roiled by the fact that the fiscal boost is going to add to inflationary pressures at the same time as the Bank of England are trying to stand down on inflation. But also the government gave no plan or no guidance in terms of how it plans to fill in that fiscal gap over the medium run. So it’s really a case of a credibility deficiency which has really been opened up as far as the market is concerned in the context of this mini budget.

Bipan Rai: Welcome to The FX Factor podcast. This is our first episode in quite some time. And firstly, I want to extend a warm welcome to our guest speaker today. Welcome to the podcast, Jeremy. It’s been a while since you’ve been on.

Jeremy Stretch: Indeed. It’s very nice to be invited back, Bipan, so I’m very pleased to be back on the show, back on the podcast.

Bipan Rai: Excellent. And to our listeners, we’re going to be focusing a lot on what’s happening in the UK right now. And again, there’s a lot to get through. There’s also a lot of places where we can start. I mean, there’s negative real incomes and in the United Kingdom, poor productivity and growth, generational levels of inflation, plus high energy costs for households, a lack of stability from a political lens, also arguably monetary policy that is behind the curve alongside the traditional large current account and fiscal deficits as well. And you layer on top of that a now collapsing currency. Also, we could throw in the fact that the national soccer team has been underperforming and the fact that the queen is dead. But Jeremy, can it possibly get any worse for the United Kingdom right now?

Jeremy Stretch: Well, thank you Bipan for that gloriously uplifting introduction there. And you really have encapsulated the misery that is clearly evident here in the UK. Now, of course, I’m based in London. That’s London, England, not London, Ontario, although actually in the current context, I think I probably would prefer to be in Ontario because you’re absolutely right that the problems that the UK is facing are myriad in terms of their nature and in a sense the period of national mourning that the UK recently undertook in the context of the aftermath of the death of the Queen, allowed a little at least a period of pause and reflection and taking us away from what is an incredibly difficult economic environment, which has only got worse in the context of the recent mini budget. And I use the word mini budget advisedly because it was anything but that. And the ensuing sell off that we’ve seen in the fixed income space and the collapse in the currency. So it is a situation where problems are legion.

Bipan Rai: Right. So let’s focus a bit on what’s happened of late and of course that mini fiscal budget that you mentioned. What is it within that last fiscal update that has markets in such a tizzy?

Jeremy Stretch: Well, I think that the big thing is the fact that the government has announced that it’s pushing through some unfunded tax cuts. Now, some of those tax cuts were very well trailed and in essence, they’re in one case only, really reversing a tax hike that was put in place back in April in terms of the payroll tax and postponing or suspending the proposed increase in corporation tax. But the combination of those two factors will have reduced the net tax paid by around 30 billion sterling per annum, which in itself is not a major issue. But the other problem is the fact that the government have now layered on top of a significant degree of fiscal easing in terms of significant tax cuts. And those tax cuts are again unfunded. And the markets were slightly roiled by the fact that the fiscal boost is going to add to inflationary pressures at the same time as the Bank of England are trying to stand down on inflation. But also the government gave no plan or no guidance in terms of how it plans to fill in that fiscal gap over the medium run. So it’s really a case of a credibility deficiency which has really been opened up as far as the market is concerned in the context of this mini budget, because if the government doesn’t hit its perceived target of two and a half percent GDP over the medium run, then its fiscal shortfalls are going to be long lasting and that’s going to create indigestion in the fixed income space.

Bipan Rai: Gotcha. So help me understand this because we hear this all the time from central bankers. This is really a supply side driven problem. And really, if you can get some sort of incentive on supply side really to invest and expand capacity, that should arguably be a good thing. And I know that corporate tax cuts or at least the cancellation of planned tax hikes for next year was part of the fiscal budget. But why were markets caught off guard by what was announced last Friday, if it’s so well anticipated? And why is this such a bad thing for markets in general in the UK?

Jeremy Stretch: Well, I think one thing that we have lost sight of in the context of that mini budget is there were some items and elements in there which actually were quite constructive. So things like an extension of capital allowances in terms of providing impetus for business investment, that was good news. And that will help to provide some degree of supply side impulse. And as you say, the suspension of that corporation tax increase should in essence provide scope for additional business investment over time. So that’s the good news. But I think it’s just this issue that there is this questioning as to the ability of the fiscal plans and the fiscal measures once they’re enacted, to really drive growth to a sufficient degree, that they will hit those growth targets. And as I say, we’re also seeing this sort of significant increase in gilt issuance. So gilt issuance for the current financial year was increased by 62.4 billion sterling, so roughly 30% or so in the context of last week’s decision. And so that just provides additional sort of gilt issuance at a time when inflation is going to be somewhat higher. And that really has caused markets just to be a little bit destabilized because, of course, there is another factor at play and that comes in the context of the Bank of England who are just about to embark in terms of QT, i.e., selling government bonds back into the bond market starting next week. So we’ve got a massive increase in issuance, we’ve got fiscal easing, which is going to provide a greater inflationary impulse and inflation was already going to be higher and probably more protracted in the UK than elsewhere. And the combination of those factors is proving to be very challenging for markets, particularly when there’s no sort of benchmark provided in terms of an impact assessment, in terms of these forecasts, which again provides a little bit of a check and balance against the Government’s plans that was missing from last Friday’s mini statement.

Bipan Rai: Okay. So explain the rationale of income tax cuts, though. I mean, I understand from a corporate side you want to explain the supply side and whatnot, but what’s with the income tax cuts that were announced last week from the chancellor?

Jeremy Stretch: Well, of course, the income tax cuts that were announced by the chancellor, well, they come in two different perspectives or two different dynamics. Now, the first thing we should remember is that these income tax cuts are not immediate. They will only take place at the start of the financial year. Now that in the context of the UK means the start of or in early April next year. So they’re not immediate. The payroll tax changes or the reverse of the payroll tax increase that we had earlier in the year that comes into place in November. But the actual income tax do not become effective for another six months or so. In the context of the reduction in the lower or the standard rate of income tax, now, that in a sense is a means or a mechanism to provide more funds to the average consumer. So to offset the impact of higher prices because of course, even with the energy price cut the government announced as part of that fiscal package, there is still going to be a substantial increase in the price of energy being paid by consumers. So it’s an effort to put some money back into consumers’ pockets in order to try and facilitate some degree of demand. But of course that’s somewhat counter to the Bank of England’s plans or the necessity to bear down on inflation. The tax cuts at the top end of the income strata, so the removal of the 45% alternative tax rate on incomes above 150,000, now that has a much less obvious justification in terms of macroeconomics. It’s a symbolism. It’s a suggestion that obviously Britain is open for business and it wants to attract high earning and significant levels of entrepreneurial individuals. But actually, in terms of the revenue generation, it’s relatively modest, but it’s more a symbolic gesture. But of course, from a political perspective or a political signaling perspective. And of course, remember, this administration under this draft has only been in place for a couple of weeks. It does provide an opportunity or an issue in terms of providing additional funds for wealthier consumers at the expense of those other lower income starters who are being hit disproportionately by the inflationary pressures that are being writ large across the piece.

Bipan Rai: So if I understand things, the reason why the market is punishing, this budget is twofold. One is that it’s unfunded, right? It’s lead to this perception of fiscal our guess. And secondly, is the timing. It’s really coming at a time when the Bank of England is moving the other way and actively and conducting active QT of gilt sales. Is that an accurate assessment?

Jeremy Stretch: Yes, I think it probably is. I think that normally when we have a fiscal event in the UK so we can have a budget or an autumn statement as they’re known, those are normally or routinely accompanied by a forecast from the Office for Budget Responsibility. Now that’s a body that was instituted back in 2010 by the Conservative government under David Cameron and George Osborne to effectively provide independent assessment of both economic dynamics, as well as providing some assessments in terms of the borrowing strategies. Now, the fact that new Chancellor Kwasi Kwarteng did not allow the OBR to produce an assessment to go alongside last week’s fiscal event certainly led to some skepticism as to whether the government were really meaning to really correspondingly reduce their budget deficit over the longer run. So it suggested that that fiscal rules are being suspended so that played into the narrative of the unfunded tax cut. But also there is this issue, as you quite rightly identify, in terms of fiscal and monetary policy being effectively coming into something of a collision course. And that was one of the interesting dynamics when we had significant degrees of speculation about a potential intermeeting rate hike from the Bank of England, because, of course, if the Bank of England had followed through with that, when the speculation was elevated over the course of the ensuing 24 to 48 hours after that mini budget, that would have underlined that the bank perceived that the policies that the government were putting through were creating greater inflationary pressures and were needing to react in an emergency fashion. So it’s the disconnect between fiscal and monetary policy as well as that lack of fiscal credibility in terms of having forecasts and impact assessments which you would normally get to go alongside a budget being published as normal.

Bipan Rai: All right. So I got a two part question on the currency here. First things first, why is the sterling taking the brunt of the pain here at a time when gilt yields is actually rising? This is a question that I’ve been asked a few times. And of course, there’s different theories as to what this is. But a simplistic way to view foreign exchange, especially in the developed market space, has been whenever you see nominal interest rates rise, that tends to correspond to currency strength. Can you walk us a bit through why this is not the case this time around? And secondly, for cable or sterling versus the US dollar, can we break below par in the coming months?

Jeremy Stretch: Well, I think it’s an interesting sort of two part question. So in a sense, I think the UK, of course, is a developed market which has deep and meaningful government bond markets. So it’s very liquid. But that liquidity, I think, is coming back to bite the valuation of the currency in the current environment. Now, going back to the most recent data that we have in terms of international holdings of gilts going back to July, we saw foreign investors selling in the region of just over 16 and a half billion pounds worth of net gilts in the month of July. Now I think subsequently that through the month of August and September that net outflow of foreign holdings of UK government bonds, i.e. gilts, has accelerated and amplified. And so I think what we’re finding is that investors are voting with their feet. They’re very mindful that this context of gilt sales coming from the Bank of England over the course of the next few weeks alongside this massive increase in issuance, is causing international investors to flee to the sidelines and that’s causing gilt yields to go up. So in a sense, the U.K., which is, of course, as I say, a developed market with deep liquidity, is acting rather more like an emerging market in the context of its market reaction that we’re seeing market interest rates going up, high yields or nominal interest rates rising. But at the same time as we’re seeing the currency underperforming or losing value. So in a sense, it is very much a reflection of that sort of very unusual circumstance that because investors have lost confidence and there is this credibility deficit as far as the UK financial backdrop is concerned, that nominal yields are rising and the currency is falling at the same time. There isn’t this presumption that the widening and spreads which have been very significant in terms of both against the US and against the euro or German bonds, has provided little respite for the currency. Now, in terms of your second part of the question, in terms of the parity threshold, well, I think it’s interesting because I was talking to one of our options structurers two or three weeks ago and we were discussing the pricing in the market. There is roughly anticipating maybe a 25% probability of a parity test within the next 12 months. Now, I was talking that those and looking at those probabilities of parity this morning, now in the one month it’s looking at maybe a 20% probability of parity, but within the next six months, that probability is priced at around 45%. So there is a high risk of that parity threshold being tested because, of course, in the early part of this week when we did see thinner markets in the Asian time zone, we did test all-time lows against the US dollar at 103.50. So we have got pretty close to that parity threshold. Yes, I think there is some questioning as to whether markets are already moving quite short of sterling. We’ve seen that already in terms of real money players, but I think the leverage community still has scope for additional short positions to be put in place. So I think it does suggest that that parity threshold is going to remain under threat. And I think probably the greatest respite that the Bank of England or the UK monetary authorities may have in terms of that parity threshold would be a moderation in terms of the valuation of the dollar. But in terms of the current conditions and the dynamics that are in play for the Fed, it still seems most likely that we are going to have a test towards that parity threshold, but I’m not sure that we would necessarily warrant or the UK warrants a perpetual fall in terms of the value of sterling beyond that. So I think it’s a parity test, but I’m not sure necessarily even with the significant degrees of uncertainty and negativity we have in place, that it’s a scenario which would suggest that if we test that parity and then blow through it and continue to see sterling cheapening exponentially.

Bipan Rai: All right. So in terms of stabilizing the currency and ensuring that we don’t say get a meaningful move to par or even below par, I mean, would the Treasury consider conducting intervention in the FX markets similar to what we saw the Ministry of Finance conduct in Japan last week?

Jeremy Stretch: Well, I think it’s interesting and I think there’s certainly a historical ghost, which I think is stalking the monetary authorities here in the UK in the context of both emergency rate hikes and or attempts to try and stabilize the currency. And that takes us all the way back 30 years ago or just over 30 years ago to the ERM crisis in September 1992, when the UK governments, under the auspices of the Bank of England, attempted to keep sterling within the exchange rate mechanism by defending the currency and then ultimately by emergency rate hikes. Now that proved to be remarkably unsuccessful. And I think that historical precedent I think has and does still characterize and cause some consternation as far as the monetary authorities are concerned in the UK. But there is a secondary issue and that comes back to the actual fiscal firepower or the financial firepower that the Bank of England or Her Majesty or His Majesty’s, I do apologize, His Majesty’s Treasury. I mean, all of us in the UK need to get used to this new titleage. His Majesty’s Treasury has relatively limited firepower because in the context of the intervention that we saw from the Ministry of Finance in Japan just over a week ago, the estimates were in the region of 24 or 25 billion pushed through the market in terms of the context of that one day intervention. Well, in terms of the Bank of England, its personal balance sheet doesn’t even equate to that much. And if you include the Treasury balance sheet, you’re probably only looking at around 80 billion of potential reserves in order to put through in terms of financial market intervention. So you’re talking about a relatively limited degree of firepower. And of course, markets know that if you have limited firepower, then it’s very difficult to really have a meaningful impact. And as we also saw from the evidence from the Bank of Japan Ministry of Finance, that solo intervention or a unilateral intervention, for a small period has a very limited impact and doesn’t really deal with the or alleviate the fundamental problems.

Bipan Rai: Exactly. And the other option I suppose we could talk about is an intermeeting hike from the Bank of England. Now, I know that’s been the focus over the past couple of sessions precisely for the reasons that you mentioned. It’s just that there aren’t enough foreign exchange reserves available for the Treasury to conduct any sort of meaningful intervention to stabilize the pound. But what about intermeeting rate hikes? I know the market’s been quite aggressive in pricing that in. What is the likelihood that the Bank of England conducts or hikes rates before the November 3rd meeting in your opinion?

Jeremy Stretch: Well, it was certainly evidence that in the immediate aftermath of the mini budget at the end of last week and certainly over the weekend of the beginning of this week, the market and the chatter about a potential emergency rate hike was relatively significant. There was a lot of speculation about a potential Bank of England statement accompanying that through the course of the Monday session of the first session of this week. But ultimately the language used by the Bank of England in their final statement, which came after the gilt marketed closed on the Monday after the fiscal event, was very much reflective of the fact that the bank will continue to monitor the variables in play in terms of the fiscal easing and how that will imply changes to their inflation profile. But the bank are very concerned about looking at it through the prism of the usual forecasting process and the Bank of England update their forecasting model once a quarter. The next meeting on the 3rd of November will include an updated set of forecasts. So what the Bank of England are hoping or intending to do is to put into that forecast model the change, the dynamics that have been evident since they last ran their model in August. So that includes the electricity price guarantee. Now that will reduce probably inflationary profile certainly for Q4 by around 2%. So that probably takes the Q4 peak down to around 11% rather than the 13 that the bank had assumed back in the summer. But then also the bank will have to incorporate the fiscal easing so that potential additional spending that will come from those tax cuts through the course of next year, as well as the impact of imported inflationary pressures, buying that 10% reduction in the valuation of sterling that we’ve seen over the last month. So the bank are very keen to try and keep everything encompassed within their normal rhythm of the forecasting process. I think if the bank were to consider an intermeeting hike, they would have to be very, very aggressive in order to try and have any real impact. But even if they were to reflect by 200 basis points yesterday, which was the speculation, I’m not sure necessarily that in itself would have particularly dealt with the problem, because we’re still talking about or we’ve still been evidencing a gilt market which has been effectively broken over the course of the last two or three sessions. So I think even an emergency rate hike in itself wouldn’t necessarily have dealt with the fundamental problems. And I think the market would have merely come back and said, well, is 200 basis points enough? Do we need to do more in order to try and renormalize the broader sort of market perspective? I think the lack of confidence, I think we’re just being amplified by the shock factor of an intermeeting move. So I think the bank will be very keen to try and hold on until a 3rd of November. We’ve had the chief economist Hugh Peel already suggesting the bank is ready to take unpopular decisions if necessary. But I think that ultimately probably implies a faster pace of tightening than they would have otherwise have been assuming. But I’m not sure necessarily we’re in a scenario yet where the bank is either thinking about intermeeting hikes are also more significantly, I’m not sure that the bank will meet market expectations in terms of the degree of tightening for that November meeting either. I suspect the bank will be probably much averse to looking to anything more than maybe 100 basis points of tightening in November, perhaps following that up again in December.

Bipan Rai: So, Jeremy, let me ask you this, because this is something that a lot of us over here on this side of the pond have been trying to grapple with. I mean, you’ve got this level of inflation in the United Kingdom and you’ve got a single mandate central bank. Correct me if I’m wrong, the inflation mandate is the one that takes precedence. Is that correct?

Jeremy Stretch: Correct. They have no other mandate. They have no dual mandate like the Fed. It is purely inflation.

Bipan Rai: It’s purely inflation. So why are they moving slower than every other central bank or most central banks, I should say, in conducting the incremental rate hikes they’re moving in terms of 25 and 50 basis points, whereas we’ve seen other central banks move by 75 or even in some cases 100 basis points. Why is the Bank of England moving slower incrementally?

Jeremy Stretch: I think as all central banks realize and recognize that obviously impacting inflation in the course of the next 6 to 12 months is very challenging because of course there are already significant dynamics already baked into the inflation profile. But as far as the Bank of England is concerned, they have their forecast model and their forecast profile and what they aim to achieve is to get back to that 2% inflation dynamic over the forecast horizon. Now, the Bank of England’s forecast profile runs out to three years. So they have a protracted period in order to encourage and get inflation back to that 2% target threshold. But if the bank is following slavishly their economic projection model and their CPI profile, then as of the August MPR, which of course is the most recent set of inflation numbers that we have from the bank, at or on the basis of market rate expectations at that time, they’re expecting inflation to materially undershoot the target by 2025. So by that remit, even though they knew that and they were anticipating that inflation would have potentially reached a peak north of 13% in the fourth quarter of this year, according to their forecast model, they were set to materially undershoot their inflation profile over the course of a three year time horizon and according to their assumptions and within their model, even if they’d left rates completely unchanged in August, they were still expecting inflation to be back some one and a half percent by 2025. So the bank, if they follow slavishly their model, suggests that they do not need to be as activist as some of the other central banks. And they’re assuming that this inflation spike, which has been amplified, particularly in the UK because of the specific dynamics of the energy price market, which has seen significant jumps or bumps in inflation due to energy prices. We saw that back in April this year when inflation increased by two and one half percent in one month because of the resetting of the energy price gap. So once those energy price dynamics are starting to drop out of the system, we now have the energy price cap, which will preclude energy prices moving up exponentially for the next two years. That would suggest that the inflation profile is still going to besubpar over the 2 to 3 year time horizon, and that to the Bank of England’s perspective allows them an opportunity to be a little less aggressive. Now, the market doesn’t necessarily perceive that the bank has that time and has that ability to be less aggressive. And of course, it was in the course of the last session or two, we’ve been pricing in rates getting up towards 6% by the middle of next year. But the Bank of England’s presumption is that the lower inflation profile compared to market expectations allows them to be less aggressive. So that’s why they’ve only just moved to 50 basis point flips back in August. We’ve obviously seen two 50 basis point moves now. The MPC have never, as yet, moved by more than 50 basis points in their 25 year horizon. Now it looks likely they will be forced to do that in November. But I think still the terminal rate in the UK will be substantially lower than that price for the market, which is now in that sort of five and a half to 6% range over the course of the post-budget period in the last couple of sessions.

Bipan Rai: Okay. So very quickly to wrap things up here, what is the way out politically? What happens with these texts? Does this budget plan get passed? And is there a rebellion against trusts based on what we’ve seen from market dynamics or is it steady as she goes from here on out?

Jeremy Stretch: Well, it’s quite remarkable that Liz Truss was only anointed as the UK prime minister by the Queen, and that was one of her last and final acts as the sovereign back at the beginning of this month. So we’re only talking about a prime minister who’s been in situ for less than one month and already we’re talking about how long she may remain in office. So that in itself is quite a remarkable feat. And certainly the UK political atmosphere has been remarkably febrile since the Brexit vote in 2016, with now the UK on its fourth Prime Minister. Yes, I think Liz Truss is going to remain under some pressure, but I think there is one sign of some potential movement and that comes by virtue of the fact that the Chancellor has announced that he will be announcing his medium term fiscal strategy, now not until the 23rd of November, but there is a medium term fiscal strategy on the horizon. On accompanying that medium term fiscal strategy, so that gives him an opportunity to outline some fiscal rules and some means or mechanism to try and placate the market and allow some degree of confidence to come back into the market. Alongside that fiscal statement, we will have the expected forecast from the Office of Budget Responsibility. So those two factors in terms of the fiscal strategy or the framework, as well as those independent forecasts which were lacking last week, are set to be forthcoming in a couple of months’ time. Now, that, of course, is a long way away in politics. Will the budget measures pass? I suspect they probably will, because the Conservative Party are probably just about going to give Liz Truss enough slack in order to push through this process, this budgetary package at this juncture. But I think there will certainly be some questioning as to whether the means and mechanism in terms of the introduction of these measures was mishandled and there was a lack of preparation in terms of the market, in terms of some of those extreme dynamics which created this real indigestion as far as the gilt market are concerned. So I think there is some slight optimism ahead in terms of that fiscal strategy, but it’s a question of markets need to find a clearing price. And I think we’ve probably found that now that we’ve seen UK bond yields moving substantially north of 4% to try and provide a little bit of appetite for international investors to come back and look at U.K. paper at slightly higher yield levels.

Bipan Rai: All right. Excellent. Jeremy, this has been fun. We’ll have you back on. And hopefully things are a little bit more calmer the next time you do come on.

Jeremy Stretch: Well, thank you Bipan. And hopefully by the time I come back on that the mighty proud pound will still be worth more than 1 CAD. But that might not be the case.

Bipan Rai: (laughs) Excellent. All right. Thank you, everyone. And we’ll be back in a few weeks for another episode. Cheers.

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