by Simon Derrick
Back in July I argued that alarm bells should be ringing about the Pound’s performance with politics and the outlook for the economy having become the major driving force for the currency in 2022. It seemed clear that if the new Conservative Party leader (and therefore Prime Minister) veered towards a more populist fiscal policy then Sterling could come under increased pressure throughout the autumn and winter. Given that this is pretty well and much what has happened, the question now is what happens next.
It should be noted that there are a couple of positives for the Pound that should not be ignored. The first is the Bank of England’s timely intervention in the Gilts market following what they reportedly characterised as a “run dynamic” developing on Wednesday. With a buyer of last resort emerging some calm was restored both in UK asset markets and the Pound. That emergent stability was still in evidence on Thursday, encouraging the view that the worst of the immediate crisis might be over. This helped reinforce the second positive which is that, typically, the worst of a Sterling crisis (whatever Patrick Minford might feel about such a term) is usually behind us by the time it makes the front pages of the UK press.
If the worst of the initial crisis is now, hopefully, behind us then is there anything to worry about over the medium term? Unfortunately, the answer is probably yes.
The first thing to consider are the actions of the BoE itself. While it’s hard to argue they had any choice given the situation they faced, their actions on Wednesday do come with consequences. Halting plans to sell down bond holdings and instead committing to buy up to £5 Bn a day of gilts for 13 days opens the Bank up to criticism that it is potentially monetising the government’s planned increase in borrowing of £72 Bn in the current financial year. While it is absolutely clear officials will deny this is the case, even the slightest suspicion that the BOE is monetising debt could weigh on Sterling over time.
If monetising government debt is a bad look for a central bank, it should also be noted that it hardly reflects well on the government, especially given that their mini budget will likely reduce tax revenues by in excess of £40 bn. To give the appearance of funding tax cuts via debt monetisation while at the same time the Treasury is asking all government departments to find “efficiency savings” provides easy ammunition for critics who wish to characterise this new government as caring only for the wealthy.
While the government might be able to weather this uncaring look (hardly a new jibe at the Conservative party), financial ineptitude might be a tougher issue to tackle given it has worked hard since the ERM crisis of 1992 to re-establish credentials as the party of financial competence. The government has gone out of its way to claim the financial market volatility that emerged directly after the Chancellor gave his mini-budget Friday last had nothing to do with what he said; the hard reality, as I highlighted last week, was that it did. To have not thought about this beforehand and then to deny any responsibility afterwards puts a fairly significant dent in the government’s reputation for financial literacy.
Coming at a time when the Conservatives are already trailing Labour by 17 percentage points in two polls and the best odds on Keir Starmer being the Prime minister after the next election are currently 4/6, this represents a fairly spectacular own goal. It also represents a slow but steady drag upon Sterling over time. It is important to note that this is not a reflection on the economic competency or otherwise of a potential Labour administration. Neither is it a comment on how Sterling would perform under such a government. Rather, it is simply a note on how the Pound has performed before ahead of elections when Labour has been doing well in the polls.
Perception, then appears to be the key factor in the months ahead for Sterling. Firstly, the perception that the BoE might be monetising part of the government’s spending plans is unlikely to help the currency. Secondly, the loss of the Conservative Party’s reputation for fiscal competence and the growing likelihood of a Labour government after the next election will act as a break over time. Looks, looks, looks.