The Pound (GBP) had a rough start to the week amid political developments in London. Sterling fell 1%, the largest decline since April. Meanwhile, long-term gilt yields rose to the highest they’ve been in 27 years. Higher, even, than during Liz Truss’ “mini budget” debacle, and a sign that the pound could be once again at risk for major volatility.
Rumours have once again circulated that Prime Minister Kier Starmer is considering canning the Chancellor. This is the third time in less than a year that No 10 has had to come out to quash speculation that Rachel Reeves will be replaced. Each time, the response from the Prime Minister’s office seems to be slower and less convincing. A shift at the top job in the Treasury could also send the pound reeling.
Dropping the Pound
The most proximal event to cause the Pound (GBP) to decline was the “mini reshuffle” in the Cabinet. No major jobs were changed, but the Prime Minister appointed three economic advisors to his team. This has had differing interpretations in politics. On the one hand, government supporters have talked about how this has “beefed up” the economic team ahead of the Budget. Others have said it undermines Reeve’s position. Meanwhile, markets have acted with caution, worried that the calming influence of the Chancellor might be diminished.
Long-term yields rose in a sign that market participants are increasingly unsure that the UK will manage to pay its bills. One of the ways a government can manage a large debt and deficit over a long period, such as the UK, is by printing money. This increases inflation, which enables the government to increase its nominal revenue. The downside is that creditors ultimately lose real value. To compensate for this risk, they demand higher interest rates, particularly in long-dated Treasury bonds (in the UK’s case, gilts). Consequently, higher long-term debt is often a sign of loss of confidence by the market. It also makes it more difficult for the government to borrow money, exacerbating the debt problem.
The Autumn Budget Problem
If the market loses confidence in the government, then the currency can weaken substantially. The British government is facing a significant test in the upcoming Budget, where it must meet rising expenses while generating insufficient revenue despite higher taxes. Markets are concerned that an eventual deficit will leave Reeves with two difficult options that are bad for the Pound (GBP).
The first is raising taxes, which would likely slow growth and make investing in the UK less attractive. Investors would be less likely to buy pounds or would outright sell them, and put downward pressure on the currency. The second option is to deficit spend, which would undermine the value of the currency through inflation.
Saved by the Economy?
The way out of this conundrum is if the economy surges, and the state can collect more taxes. So far, the British economy has outperformed expectations, with a resilient labour market keeping wages high. Any indication that the UK economy is going strong would help alleviate worries about the Budget and support the Pound (GBP).
Attention is now on Friday’s release of UK retail sales figures to see if consumers are still supporting the economy. A disappointment in this figure could drag on sterling as traders renew worries that the economy is slowing down. July UK retail sales are expected to decelerate to 0.2% growth compared to 0.9% a month earlier.
