British borrowing costs surge, sterling plunges after new economic plan

By Amanda Cooper and Alun John

LONDON (Reuters) - British government bond yields surged by the most in a day in over three decades on Friday, the pound slid to a fresh 37-year trough against the dollar and stocks hit six-month lows after UK finance minister Kwasi Kwarteng laid out a series of tax cuts in a bid to boost growth.

The package, estimated to cost 45 billion pounds ($50 billion) by the financial year 2026/27, was the largest at a single event since 1972, according to the Institute for Fiscal Studies, a think tank.

Income tax cuts, a drop in property taxes, tax-free shopping for overseas visitors and the scrapping of a planned corporation tax rise are all aimed by the government at giving households and businesses a boost.

To fund the cuts, plus a multi-billion pound scheme to subsidise energy bills, the government's debt management arm said it would raise its borrowing plan for the current financial year by around 45% to 234.1 billion pounds ($260 billion).

The bond market went into a tailspin, with yields on the five-year gilt - one of the most sensitive to any near-term shift in interest rate or borrowing expectations - up by half a percentage point. This was the biggest one-day rise since at least late 1991, according to Refinitiv data.

"This huge fiscal event is a radical economic gamble; a 'Go big or go home' gamble that will put UK debt on an unstable footing," said Bethany Payne, global bond portfolio manager, Janus Henderson Investors.

"We had been concerned over the ability of the Bank of England to sustainably sell gilts through the quantitative tightening due to start on Oct. 3, but today we are asking whether quantitative tightening is over before it even began."

Bond holders were already rattled by inflation and by the prospect of more interest rate hikes from the Bank of England (BoE), which on Thursday raised rates by a half-point to 2.25%.

This is "fiscal stimulus at a time when the Bank of England is already worried about aggregate demand being too high, and it's highly likely to force the Bank of England to raise rates even more than we thought they were going to otherwise," said David Page, AXA Investment Management head of macro research.

STERLING BATTERED

The pound tumbled after Kwarteng's speech, and in afternoon trading was down around 3% against the dollar to trade as low as $1.0896, its weakest since 1985. It also weakened significantly versus the euro, yen and Swiss franc.

Even before Friday's announcement sterling had been under severe pressure. It is now down 10% since the start of July and on track for its worst quarter since 2008, pressured by the strong dollar, sluggish British growth and red hot inflation.

The FTSE 100 share index dropped 1.97%, hitting its lowest level since March.[.L]

In another sign of stress, the cost of insuring Britain's debt against a default jumped to its highest level since mid-2020.

S&P Global Market Intelligence data showed 5-year credit default swaps (CDS) - derivative instruments that debt investors typically use to hedge risk or bet against something - jumped 3.5 basis points to 34.5 points, an unusually large move for a G7 economy.

ING analysts said in a note that as there is not much liquidity in sovereign credit default swaps for Britain, currency markets were probably the easiest vehicle to trade UK country risk.

"Investors will take great interest in what the rating agencies have to say about UK fiscal plans," they added.

"The UK's long-term sovereign outlook is currently stable at all three of the rating agencies... The risk of a possible shift to a negative outlook will come when the ratings are reviewed on 21 October (S&P and Moody’s) and 9 December (Fitch)."

($1 = 0.9044 pounds)

(Reporting by Alun John, Harry Robertson and Yoruk Bahceli; writing by Amanda Cooper; Editing by Toby Chopra, Susan Fenton, Kirsten Donovan)