Britain’s fascination with Reaganomics is rejected by the markets

Truss has now set the country on an economic path completely at odds with most, if not all, major global economies.

Hannah McKay | Reuters

LONDON — New U.K. Prime Minister Liz Truss may have talked a lot about “stable finances” during her campaign this summer, but no one could have predicted the slew of tax cuts unleashed just weeks after her tenure in Downing Street.

Described as a “mini-budget” by finance minister Kwasi Kwarteng, Friday’s budget announcement was anything but a volume of tax cuts not seen in Britain since 1972.

Truss – whose ‘Trussonomics’ policy has been likened to that of her political idols Ronald Reagan and Margaret Thatcher – has now set the country on an economic path completely at odds with most, if not all, of the world’s major economies as inflation and a cost of living crisis is brewing in Europe.

It was seen, even by some of her supporters, as a political and financial gamble with Truss yet to face the wider British electorate in a national vote – unlike her predecessor Boris Johnson.

Market players immediately predicted that Britain would have to ramp up bond issuance and significantly increase its debt load to pay for the cuts – uncharacteristic of past low-tax Conservative governments.

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UK bond markets tumbled on Friday as investors shunned the country’s assets. Yields (which move inversely to prices) on 5-year gold rose half a percentage point – which Reuters reported was the biggest daily gain since at least 1991.

And with bonds falling, sterling has also been sent into freefall after hitting 37-year lows against the dollar in recent weeks. It closed Friday down nearly 3.6% against the dollar. In the week it lost 5% and is now down 27% from just before the 2016 Brexit vote.

Wall Street banks are now seriously considering a break below parity with the US dollar – for the first time in history – and many commentators have likened the pound to an emergency market currency.

Left-wing newspaper The Guardian called it a “budget for the rich” on its front page on Saturday, while The Times called it a “big tax gamble”. The right-wing Daily Mail called it a “real Tory budget”, while Kwarteng himself said it was a “very good day for the UK”, declining to comment on currency moves.

ING analysts said in a research note that investors are concerned that the UK Treasury is now effectively committed to borrowing indefinitely for these tax cuts and that the Bank of England will have to respond with more aggressive rate hikes.

“For us, the size of the jump in gold yields has more to do with a market that has become dysfunctional,” ING Senior Rates Strategist Antoine Bouvet and Global Head of Markets Chris Turner said in the note.

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“Some indicators…suggest that liquidity is drying up and the market is underfunctioning. A signal from the BOE that it is willing to suspend gold sales will go a long way in restoring market confidence, especially if it wants to maximize its chances of combating inflation with conventional tools such as interest rate hikes. The QT [quantitative tightening] The battle, in short, is not worth fighting for the BOE,” they added, citing the Bank’s move to normalize its balance sheet after years of stimulus.

ING also noted that the UK’s long-term outlook is currently stable with the three major rating agencies, but the “risk of a potential shift to a negative outlook” could arise when they are reviewed (October 21 and December 9).

Analysts at Deutsche Bank, meanwhile, said the “price of easy fiscal policy was revealed by the market” on Friday.

“[Friday’s] Market movements suggest there may be a credibility gap,” Sanjay Raja, senior economist at Deutsche Bank, said in a research note.

“A plan to put public finances on a sustainable footing will be necessary but not sufficient for markets to regain confidence in an economy running large twin deficits [the U.K.’s fiscal and current account balances],” he added.

“Crucially, with fiscal policy shifting to easier ground, the onus may now fall on the Bank of England to stabilize the economy, with the MPC [Monetary Policy Committee] we have more work to do to close the gap between expansionary fiscal policy and tighter monetary policy.”

—CNBC’s Karen Gilchrist contributed to this article.

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