Pound hits all-time low against the dollar following recent UK budget

UK expansive fiscal stimuli pushes pound sterling to all-time low

Following Friday’s UK extensive fiscal stimuli mini budget, the pound sterling dropped by over 7% to a record low at $1.035 versus the US dollar in Asian time zone trading.

The cross thus slipped below its 1985 low at $1.052 and scored its lowest level since decimalisation back in 1971 as the biggest tax cuts in 50 years scared off investors. The pound also fell against several other currencies, notably to a 2-year low versus the euro, before regaining some of its recent losses on short covering trades.

The pound sterling reacted negatively to the announcement of the UK mini budget’s income tax cuts, stamp duty reductions, scrapped corporate tax increases and bankers’ bonus caps as investors worry about the government’s ability to finance these initiatives without incurring a huge debt burden as the cost of borrowing is continuing to increase. This is apparent as 5-year gilt yields increased to 4.5%, a 100-basis point (bp) move since Friday.

Furthermore, as disposable income increases, there is likely to be an increase in consumer demand, further accelerating inflation and calling for more interest rate hikes.

What factors impact the value of the pound?

A country’s currency is affected by how easily and freely it can be traded and the demand and supply of the currency which is determined by a number of economic indicators, such as central bank interest rate differentials, a country’s economic growth, inflation and debt, macro-economic and geo-political events, news and future expectations regarding a country and its currency.

A country’s economic performance and outlook as well as its interest rate expectations will determine whether businesses, speculators and investors want to buy its currency (demand) or sell it (supply).

Interest rates – which are determined by a country’s central bank - play a major role in that, all things being equal, the currency of a country with higher interest rates - or anticipated higher interest rates - tends to rise against currencies of countries with lower interest rates. The reason being that speculators and businesses will buy the higher interest currency and invest in its country in order to receive the higher interest. This is known as a carry trade.

A country’s economic performance is mainly determined by its gross domestic product (GDP) – a proxy for the size and health of a country’s economy, usually measured over a quarter or a year -, as well as its consumer price index (CPI) and producer price index (PPI), on a monthly and yearly basis.

CPI is a measure of the average change over time in the prices paid by urban consumers for a basket of consumer good and services whereas PPI measures the average movements of prices received by domestic producers for goods and services sold on the domestic and/or on export markets over a given time period.

Investors and businesses compare this fundamental data country by country and, importantly, look at their future expectations before deciding in which currencies to invest in.

Why is the pound sterling trading at all-time lows?

The pound sterling had already been sliding versus the US dollar since May of 2021, by some 20% before the current sharp sell-off, as worries about the Northern Island Protocol (NIP) prompted fears of a fresh trade dispute between the UK and the EU. In addition, the US continues to pour cold water on the idea of a UK-US trade deal, and the situation regarding the NIP adds to the complexity of such a deal.

But the main event has been the recent ‘mini-Budget’ (which is ‘mini’ in name only). This has seen the new chancellor unveil a host of tax cutting measures designed to provide an economic boost and give UK taxpayers more money to spend at a time of rising prices. The problem with this is that it comes hard on the heels of the decision to spend around 6% of UK GDP on reducing energy prices, ensuring that the government deficit will increase dramatically.

This two-pronged move has worried global markets, and as a result government borrowing costs have risen. Fears of a wider global recession have driven classic ‘risk off’ moves in FX markets, and traders have continued to buy the dollar and sell sterling.

Where does the pound go from here?

Monday’s early trading saw a dramatic downward move for GBP/USD, which fell to a record low against the US dollar of $1.03. This took place in relatively thin liquidity trading conditions, which can make it easier for dramatic moves to develop. Investors and traders need to remember we are in a high volatility environment, exemplified by the equally impressive rebound from the lows of the session back to $1.07.

GDP/USD has been trending lower against the US dollar since the summer of 2021. A downtrend is characterised by a series of lower highs and lower lows, and is usually taken as an opportunity to go short in the expectation of profiting from additional moves lower.

But just as prices can be stretched to the upside in an uptrend, they can also be stretched to the downside, and we have seen this develop since Monday morning. A degree of overexcited selling pushed GBP/USD down to $1.03, but this left it nearly 14% away from the 50-day moving average.

Often, such moves can be entirely reversed in the short term, but leave the dominant trend intact. GBP/USD has not exactly rallied, but it could see another short-term recovery that see it move back towards $1.15. This would recoup the losses of the past week, without suggesting that a longer-term change of trend was at hand.

Alternately, the rebound may have already run its course, and the price may turn lower once again. In that case, a move below $1.06 could well signal a new fall is at hand.

Volatility likely to remain elevated

The pound’s travails come at a time when volatility across all markets appears to be increasing. However you choose to trade the pound’s moves, remember that risk management is still the most important factor.

Remember to ensure you have stops in place to help prevent losses becoming too large, and make sure that you do not overleverage. In general, wider stops and smaller position sizes will help investors to navigate this period.

The overall outlook for the UK economy, and for the US too, appears to support expectations of further downside for the pound. But is likely to be a volatile journey, made more so if further comments are made by policymakers in the UK.