The British pound crashed spectacularly this week – here’s why it matters

The British currency has recovered after a record crash but traders are still spooked.

The British pound has been sliding for several months but this week hit its lowest level ever against the US dollar.

The UK currency had been trading around $US1.35 at the beginning of the year but on Monday plummeted to a record low of $US1.03 in a sign of the market's concerns about the country's finances.

The pound has since recovered some ground and was trading at $US1.11 at the time of writing after the UK's central bank sought to reassure the market and intervened to buy bonds for two days in a row.

But traders believe the weakness in the British pound is here to stay unless there is a change in fiscal policy by the UK government.

Why did the pound crash?

A part of the reason for the continuing decline in the British pound has been the strengthening of the US dollar against most currencies over the last few months. Rapidly rising interest rates and a relatively bright economic outlook have attracted more inflows into the United States, boosting its currency.

But the sell-off in the British pound accelerated significantly after the new UK government under Liz Truss last week unveiled a "mini-budget" aimed at helping grow a British economy that has been under pressure because of rising costs.

The government announced massive tax cuts, wound back recent increases in levies for health and social care, cut proposed hikes to corporations tax and removed a cap on bankers bonuses.

But the tax cuts will need to be funded and investors are betting that the UK government will need to borrow significantly more money from the market to keep its services going at a time when its finances are already shaky in the aftermath of the COVID pandemic and Brexit.

Economists believe the tax cuts will also prompt higher consumer spending when inflation in the UK is already running hot at 9.9%, raising fears it will prompt the Bank of England to lift interest rates at an even faster rate than previously expected and drag the economy into a recession.

Typically, the exchange rate of a country's currency is linked to how well its economy is performing. In the case of the UK, the recent developments have led to a crash in bond prices and a sell-off in the British currency.

Why should you care?

The immediate impact is being felt by Australian investors in the stocks, debt and forex markets.

Global currency and bond markets saw a spike in volatility this week thanks to the rise of the US dollar and the collapse in the British pound, with some describing it as similar to playing in a casino.

Share markets globally have also seen volatile trading as investor sentiment takes a hit during such periods of uncertainty. Some companies listed on the FTSE have warned of the impact of a weaker pound on their revenues and earnings.

At a broader level, a continued weakness in the British pound could hit trade and commerce, because it will make Australian goods and services more expensive for buyers in the UK. The United Kingdom is Australia's fifth largest trading partner with Australian exports worth $21 billion in 2019-20.

British investment into Australia could also be vulnerable because the pound's depreciating value makes these more expensive.

What will happen now?

Economists as well as global institutions such as the International Monetary Fund (IMF) have urged the UK government to re-evaluate its plans, saying that "large and untargeted fiscal plans" will lead to higher inflation pressures and worsen inequality.

The Bank of England has also stepped into the market to purchase a sizeable amount of government debt in an effort to buy time for the UK government to consider some reversal of recent policy announcements.

Traders are now betting on the UK central bank hiking interest rates by at least 150 basis points at its next meeting on Nov. 3 as it focuses on its objective of getting inflation back to its 2 per cent target in the medium term. This would be on top of the seven rate hikes it has already delivered this year.

That means even higher borrowing costs for UK households and businesses.