UK government bows to market demands by canceling tax giveaways – Financial Professionals

After huge turmoil in the gilt and pound markets, Prime Minister Liz Truss capitulated on her growth plan. We described the Kwasi Kwarteng mini budget on September 23 as a “big gamble”, which obviously backfired dramatically.

The pound hit an all-time low against the US dollar at 1.068 and fell to 1.112 against the euro on September 26, while the yield on 30-year government bonds repeatedly breached the 5% ceiling in intraday trading, against 3.78%. the day before the mini budget.

The Bank of England (BoE) was forced to step in and buy long-term gilts as it became clear that the speed of rising interest rates had caused problems for some pension funds. However, with the BoE in tightening mode, this conflicted with its main objective of trying to bring inflation down to 2%. Therefore, the Bank is committed to providing this support only for a short period and would not become the lender of last resort to a government that had decided to throw fiscal prudence out the window.

Investors opposed it from the start

Not only was the budget plan untenable for investors, but the political optics of offering the biggest tax cuts to the highest earners generated a huge political backlash. The Conservative Party’s poll for the upcoming general election has fallen from 10 points behind its main rival Labor to more than 30 points behind in more recent polls. It would almost certainly lead to a Labor victory not seen since the 1997 election.

Kwarteng responded to the political crisis by reversing the most controversial change, the removal of the additional tax rate (45%). He also announced a budget update by the end of October which this time would include a forecast from the Independent Office for Budget Responsibility (OBR), which he had previously ruled out.

However, with BoE support coming to an end on Friday, October 14, Truss had no choice but to take further action. Truss summoned his first-choice chancellor to an IMF meeting in Washington to inform him of his dismissal. With just 38 days in office, Kwarteng became the shortest chancellor not to die in office.

Four chancellors in four months

Truss has announced that former Health Secretary Jeremy Hunt will become the new Chancellor and that the plan to cancel the corporate tax hike is being scrapped. The corporate tax rate will now increase from 19% to 25% as previously planned.

However, there were more U-turns to follow. By the close of Friday, October 14, gilt yields had begun to rise again, with the two effective rollbacks of tax cuts clearly not enough to restore confidence. Fearing what might happen in the absence of the BoE backstop, Hunt announced on the morning of Monday, October 17 that almost all of the Liberal mini-budget fiscal measures would be scrapped.

Only the cancellation of the increase in social security contributions from April 2022 would remain, as well as the reductions in stamp duty (tax on real estate transactions). Moreover, he went further. The one percentage point cut in the normal income tax rate, which was brought forward to April 2022, would remain unchanged indefinitely – more restrictive than even before the mini-budget.

In addition, Liz Truss’ flagship policy, the Energy Price Guarantee, will no longer last two years, but will be reviewed and updated in the spring, with a view to reducing its cost. We expect the Chancellor to follow the Germanic approach and encourage energy efficiency by offering a subsidized tariff on the first 70[(-80) was not found] of typical consumption, the rest being compared to market prices.

According to our calculations, the inversions announced so far could reduce government borrowing by just under £100bn or 4% of GDP by 2026-27. However, we expect government spending cuts to be unveiled in the Halloween budget statement, along with possible additional tightening measures.

Market reaction to recent events has been more positive. The pound is up just under 2% on the day against the US dollar and 0.7% against the euro. The benchmark 10-year gilt yield fell 35 basis points, and the more difficult 30-year gilt saw its yield drop 41 basis points.

While markets reacted positively, both pound and gilt yields failed to return to pre-mini budget levels. We don’t expect them to be in the short term. Given the volatility and fragility of the UK government, investors are rightly demanding a haircut on UK assets to offset the added risk and uncertainty in the policies they announce (and retract).

Less pressure on the BoE to increase aggressively

Given the withdrawal of fiscal stimulus, the BoE will be under less pressure to raise interest rates by the same amount. Money markets were anticipating a rate spike of 5.5% from the current rate of 2.25%, but that rate has now fallen back to 4.75% after the government pulled out.

However, we expect the BoE to remain dovish, and while it is expected to accelerate rate hikes at its next monetary policy meeting in November, we expect the BoE to raise rates less than expected by the markets, potentially a peak of 4.5%. This would be helpful for households facing difficulties in refinancing their mortgages, but could lead to more persistent inflation in the economy.

Can Liz Truss survive?

The story may still need a final chapter, as rumors continue to suggest that the Conservative Party may still oust Liz Truss to bolster its standing with the public ahead of the next general election, which is due to be held by January 2025. After everything, the growth plan on which she based her campaign was torn to shreds, and she had to be rescued by a colleague from the opposite wing of the party. Even friendly newspapers wonder if Jeremy Hunt is now running the country.

If Truss resigns or is expelled, then the party would be wise to put forward a candidate or unity team to replace the prime minister. A further division could trigger a general election, which may require Crown intervention.

The betting markets have a two-thirds chance that Liz Truss will be kicked out before the end of the year. Could we still see a fifth chancellor in five months? Investors naturally remain nervous.

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