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One thing we can learn from this fiasco is that the bond markets govern Britain.

  • Monday, October 17, 2022

UK Chancellor of The Exchequer Jeremy HuntA week has been a long time in both UK politics and the UK economy as markets punished Prime Minister Liz Truss and now ex Chancellor Kwasi Kwarteng for a non-costed tax reducing budget.

Announcing a fiscal stimulus package contingent upon economic growth to replace tax revenue, before explaining where the growth was coming from was not well received. Markets did not appreciate this policy when Britain has a vulnerable currency, a large national debt and trade deficit and is a major energy importer with very little winter gas storage capacity.

Tax cuts as a way to stimulate economic activity is a sound policy, historically tax revenue has risen when tax rates cut, unfortunately the timing was wrong. This in hindsight should have waited till after gas prices were falling, inflation in decline, interest rates falling and national debt falling as a % of GDP.

Liz Truss felt she could pull off a major turnaround in the UK fortunes over the next two years, but the Treasury, Bank of England, Office of Budget Responsibility and the City did not. The opinion of City analysts and traders is instantly visible in the foreign exchange and bond markets. The latter has control of the personal finances of the public.

The government has now reversed all three tax cutting aspects of the mini budget. The cut in 45% highest income tax rate to 40%, the cutting of basic rate income tax from 20% to 19% and the stop on corporation tax rising from 19% to 25% have now been reversed. The ending of the 2.5% national insurance increase will remain.

On 23rd September, the day of the mini budget, Sterling stood at US$1.14 only to fall to US$1.035 but then recovered to US$1.11 when the Bank of England stabilised gilt prices on 28Th September. Sterling was at this value when Kwasi Kwarteng stood down as Chancellor. Over that same time frame UK 10-year gilt yields were 3.7% prior to the mini budget but lifted to 4.5% soon after, fell to 3.85% when the BoE stepped in and are 4.375% today.

Now Kwasi Kwarteng career has taken the hit for a poorly considered budget, but he was not wrong about the need for the UK to correct long term weaknesses and deficiencies in the economy. Sadly, for what was positioned as an important growth budget focused on creating an investment focus for the UK with lower taxes and less regulation has now resulted in higher borrowing cost for business and home owners. This has for many wiped out any NIC savings.

There are claims that this budget has been unfairly treated by international investors as UK debt to GDP is lower than the majority of the G7 nations. The post Brexit opportunities for investment and regulatory reform which could have seen a Brexit dividend have so far come too very little including the reversal of this growth focus budget.

Unfunded tax cuts at a time of a pending recession and a cost-of-living crisis were always going to be a hard sell especially if not backed up by an independent audit from the Office of Budget Responsibility (OBR).

Fundamentally, Truss and Kwarteng did not trust the orthodoxy of the Treasury or the OBR as they held different economic visions. They wanted to challenge the economic orthodoxy that has run western economies for decades in order to stimulate growth. The Truss government thought they could beat this orthodoxy but they did not understand the power of the city and we are now paying with higher borrowing costs as gilt yields have soared.

Residential mortgage and re-mortgage costs have gone up. A 10-year fixed rate mortgage is now 5.78% as compared to 2.99% last October. A 2-year fixed rate is now 6.47%.

Liz Truss has turned to the experienced and standing of Jeremy Hunt as her new Chancellor in a bid to unite the Conservative Party. Jeremy Hunt said during his last leadership bid said UK corporation tax should be reduced to 15% to create jobs, boost investment and deliver growth.

The ending of the government immediate plans to reduce taxes was confirmed by the new Chancellor and brings budgetary discipline back to government finances. This decision was in part forced upon Jeremy Hunt by the Bank of England (BoE) not offering an open-ended commitment to gilt price underpinning. The BoE gilt purchasing programme ran only till 14th October and so Hunt’s hand was forced.

It makes little sense for the BoE to be purchasing gilts when they are seeking to run down their QE bond assets by selling them back to the market in order to tighten money supply and head off inflation. Around the world, central banks are seeking to control the inflation that was built up from low interest QE stimulus.

The budget U turn in higher rate tax and corporation tax reductions were welcomed by the Governor of the Bank of England, Andrew Bailey as a way to bring back balance to the UK books. He said ‘Flying blind is not a way to achieve sustainability’. This has been interpreted as a criticism of Kwasi Kwarteng and by association Liz Truss.

The problems for the Government have not been helped by the slow to act BoE. Andrew Bailey, has a long-standing reputation for slow and ponderous decision making and has been criticised in many quarters for being far too slow to raise UK base rates when inflation was building. The BoE were still buying bonds up until December 2021 when inflation was accelerating. The BoE pumped £400bn into the UK economy between 2020 and 2021 as they thought inflation was only temporary.

The Monetary Policy Committee that Bailey chairs, has not risen interest rates at a pace to have brought inflation under control and therefore are now more likely to have to rise rates even more to catch up for their inaction. It is expected that UK base rates will rise by 1% on 3rd November MPC meeting.

The size of the shortfall in the UK budget is £62bn which Jeremy Hunt must find in order to regain market confidence in the UK government. The £62bn will be needed for the 2026/27 fiscal year in order to stabilise Britain’s debt to GDP ratio. This gap could be filled by reasonable growth in the economy but analysts don’t see where that growth is coming from in the short term.

Goldman Sachs have reduced their growth forecast for the UK due to the worsening lending conditions and the cancellation of the plan to not to rise corporation tax from the current 19% to 25%.

This week will be interesting to see how the UK government bond market will trade after the BoE concluded its emergency support and after the tax cutting U turns that brought some orthodoxy to UK finances. So far, we have seen sterling rise against the US$.

One thing we can all learn from this fiasco is that it is the bond markets that govern Britain.

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Chris Davies

Chris Davies

Chartered Financial Adviser

Chris is a Chartered Independent Financial Adviser and leads the investment team.

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