Source: AFP
The GBP plunged on Friday, falling 3% to new 37-year lows against the USD while 5Y yields jumped the most on record after new Prime Minister Truss’s government unveiled sweeping unfunded tax cuts, raising serious risks to the outlook.
Source: Bank of Singapore, Bloomberg.
Firstly, Britain’s economy is already fragile with the energy shock from the war in Ukraine threatening to tip the UK into recession while pushing inflation up to double digits as the chart above shows.
Secondly, the budget deficit is set to jump sharply, making investors wary of government bonds. The new government already announced this month it would freeze energy bills to aid households and firms through the crisis. The cost is estimated to be GBP60 billion for the next six months.
Source: Bank of Singapore, Bloomberg.
The new tax cuts – abolishing the highest (45%) rate of income tax, cutting the basic rate by 1 percentage point from April 2023, increasing exemptions on stamp duty, reversing national insurance increases and cancelling planned corporate tax rises – will likely cost GBP100 billion more over the next five years. The UK fiscal deficit for the current financial year is thus set to balloon from an estimated 3.9% of GDP in the March budget to over 7% of GDP now. At the same time, the economy is running a gaping current account deficit at 8.3% of GDP as the second chart shows. Global investors may take fright and stop funding the UK’s ‘twin deficits’, causing a major crisis for GBP.
The Bank of England (BoE) faces an extremely difficult outlook. The plunge in the GBP and increased government borrowing to pay for the tax cuts will exacerbate inflation. We expect the BoE will now need to raise its bank rate faster following this month’s 50bps hike to 2.25%. We forecast a 75bps rise in November and 50bps in December and February, lifting the bank rate to 4.00% before recession makes the BoE stops hiking.
The GBP, however, is likely to slump below its all-time low of 1.05 against the USD hit in 1985 as investors fear UK debt is on an unsustainable, rising path now. This could cause a vicious emerging market-style spiral of higher inflation, higher yields and falling activity, resulting in the government having to make emergency spending cuts and forcing a deep recession. We thus are very wary of the UK outlook now.
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