UK Treasuries and Pound Sell Off as Kwarteng Unveils Tax Cuts

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British government bonds sold off sharply and the pound hit a new 37-year low against the dollar as investors braced for a flood of debt sales to fund Chancellor Kwasi Kwarteng’s tax cuts and energy subsidies.

The 10-year gilt yield rose more than 0.2 percentage point on Friday to 3.7 percent, bringing its increase for the week to more than half a percentage point. It marks one of the largest increases in long-term borrowing costs on record. Sterling fell below $1.11 for the first time since 1985.

Friday’s heavy selling in gilts and pounds came after Kwarteng said the government would scrap the top rate of 45p in income tax and replace it with a 40p rate. He also announced a reduction in stamp duty on property sales.

The tax cuts, which will reduce government income, come as Britain is expected to spend £150bn subsidizing energy costs for consumers and businesses. Kwarteng said the energy bailout would cost £60 billion in the first six months.

A large part of this borrowing must be financed by selling gilts. The UK debt management office increased its planned bond sales for the 2022-23 financial year by £62.4 billion. GBP to 193.9 billion

“This is an escalation of the dramatic sell-off we have already seen in the gold market over the past two months,” said Antoine Bouvet, a fixed income strategist at ING. “There’s a lot of tax relief coming on top of the energy price guarantee, and that’s spooking gilt-edged investors who now see a ton more issuance coming.”

Line chart of UK 10-year yields (%) showing gilt yields at fresh 11-year highs

Bouvet said markets also expect more aggressive rate hikes from the Bank of England to offset the inflationary impact of Kwarteng’s stimulus measures, following a 0.5 percentage point increase in Bank Rate this week. Expectations of more aggressive BoE rate hikes sent the two-year gilt yield soaring more than 0.8 percentage point higher this week.

After the chancellor’s announcement, markets priced in 0.75 percentage point hikes at each of the next three BoE meetings, taking rates to 4.5 percent.

The prospect of sharply higher interest rates did little to support the pound, which fell to a fresh 37-year low against the dollar on Friday. Sterling fell as much as 1.6 percent after Kwarteng spoke, hitting a low of $1.1078, a level last seen in 1985, according to Refinitiv data.

The drop came as the dollar continued its rally against currencies across the globe, two days after the Federal Reserve raised its interest rate by 0.75 percentage points for the third meeting in a row as it tries to tame rising inflation. Against the euro, the pound fell 0.6 per cent.

“In this type of environment with the cost of living crisis, the energy crisis . . . the chance of policy missteps increases,” said Stephen Gallo, head of European FX at BMO Capital Markets. “The currency is going to show a lot of the brunt, and it’s doing it now. “

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