Chancellor Kwasi Kwarteng’s first few days on the job saw GBP/USD hit a record low then rally over 1100 pips (approx. 1.0350 - 1.1500). 

Markets were shocked by the new Government's ‘mini budget’ prompting criticism from the IMF and then intervention from the Bank of England to stabilise frantic bond markets and reportedly rescue pension funds on the brink. 

The Government’s U-turn on its plan to scrap the top tax bracket has left markets stunned again. Volatility is expected to return when (if) the Bank of England ends its support.

Did the British pound just set a generational low, not to be seen again for years, if ever, or is this temporary relief before another slide to parity with the US dollar?

Read more to lean about what could happen next and it’s implications for Sterling.

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The tax cuts

The 45% tax rate for high earners (over £150,000) was a poor political choice. With inflation driving a cost-of-living crisis across the country, a “tax cut for the rich” went down like a sack of spuds. The U-turn on this policy has wound back some of the controversy.

BUT for markets, the critical point was that the tax cuts were part of a series of measures that would be financed with debt. More government borrowing when interest rates are rising drastically raises the chance of a default on UK government debt and would likely make  inflation woes even worse.

Investors reacted to this toxic combination of debt and inflation by dumping UK government bonds, sending gilt yields soaring and prompting the BOE's sudden intervention in the markets. 

Investors' concerns were likely not particularly related to the tax cut on top earners. It is estimated that the tax cut would mean about £3B less revenue, a small amount compared to the  total £42B package of measures.

The Bank of England

The pound has risen following the U-turn announcement, however the policy change does not substantially reduce the potential debt cost of the "mini-budget" - which was behind the initial sell-off.

It seems likely the return of confidence to UK markets and the British pound rests solely with the Bank of England’s return to quantitative easing (buying government bonds). If the central bank were to stop its intervention without any major change to the new fiscal policy plan, the gilt sell-off could easily resume alongside bearish pressure on the British pound. The BOE intervention is supposed to be temporary.

Current government policy now appears to rely on the BOE supporting UK bond markets with easy monetary policy, at least until all the budget details are known and priced in by markets. The problem is that the Bank of England had been in the middle of tightening policy to fight off inflation.

GBP/USD bottom or parity?

Sterling has seen increasing speculation that it could hit parity against the dollar but following a V-Shaped recovery, traders are split as the BOE and the UK government are. 

The bounce velocity has offered a full-blown reversal of the crash and taken the price up to the 1.15 round number, before pulling back.

If cable moves past $1.15, $1.1750 is the next ceiling, but if the bottom in then a move back towards the June highs above 1.42 is feasible. If, however, the price remains below $1.15, the $1.10 round support will come back on traders' radar. 

In the event of a breakdown below the record low of $1.0330, the 1.00 level (ie parity with the US dollar) is the next target.

Key takeaways

The Bank of England might now face the choice of allowing an inflation crisis with more QE and rate cuts or a financial crisis with no QE and rate hikes. There is a third way of raising rates while conducting QE, where the likely result is a crisis of confidence in the central bank as an institution.