UK government bows to market demands by cancelling fiscal giveaways

After tremendous turmoil in gilt and sterling markets, Prime Minister Liz Truss has capitulated on her growth plan. We described Kwasi Kwarteng’s mini-budget on 23 September as a “big gamble”, which has clearly backfired in spectacular fashion.

The pound hit a record low against the US dollar of 1.068 and fell to 1.112 against the euro on 26 September, while the yield on 30-year government bonds broke through the 5% ceiling several times in intra-day trading, compared to 3.78% the day before the mini-budget.

The Bank of England (BoE) was forced to step in and buy long-dated gilts as it became obvious that the speed of the rise in 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 lower inflation back to 2%. Therefore, the Bank was committed to only offering this support for a short period, and would not become the lender of last resort to a government that had decided to throw fiscal prudence out of the window.

Investors objected from the start

Not only was the fiscal plan untenable for investors, but the political optics of offering the biggest tax cuts to the highest earners generated a tremendous political backlash. The Conservative Party’s polling for the next general election has fallen from being 10 points behind its main rival Labour, to being over 30 points behind in more recent polls. This would almost certainly lead to a landslide victory for Labour not seen since the 1997 election.

Kwarteng responded to the political crisis by cancelling the most controversial change, the scrapping of the additional (45%) rate of tax. He also announced a fiscal update by the end of October which this time would include a forecast from the independent Office for Budgetary Responsibility (OBR), which he had previously excluded.

However, with BoE support drawing to a close on Friday 14 October, Truss had little choice but to take further steps. Truss summoned her first-choice chancellor from an IMF meeting in Washington to inform him of his dismissal. With just 38 days in the post, Kwarteng became the shortest serving chancellor not to die in office.

Four chancellors in four months

Truss announced that former health secretary Jeremy Hunt would become the new chancellor, and that the plan to cancel the rise in corporation tax is now being reversed. The corporation tax rate will now rise from 19% to 25% as previously planned.

However, there were more U-turns to follow. By close on Friday 14 October, gilt yields had started to rise again, as the two effective tax cut cancellations were clearly not enough to restore confidence. Fearful of what could happen in the absence of the BoE’s backstop, Hunt announced on the morning of Monday 17 October that almost all of the fiscal giveaway measures from the mini-budget would be dropped.

Only the reversal of the increase in national insurance contributions from April 2022 would remain, along with the cuts to stamp duty (housing transaction tax). Moreover, he went a step further. The one percentage point reduction in the standard 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’s flagship policy of the Energy Price Guarantee will no longer run for two years, but instead be reviewed and updated in the spring, with a view of reducing its cost. We expect the chancellor to follow the Germanic approach and encourage energy efficiency by offering a subsidised rate on the first 70% to 80% of typical consumption, with the rest facing market prices.

By our calculation, the reversals announced so far could reduce government borrowing by just under £100bn or 4% of GDP by 2026-27. However, we expect a squeeze on public spending to be unveiled at the Halloween fiscal statement, along with potentially further tightening measures.

The reaction in markets to recent events has been more positive. Sterling is up just under 2% on the day against the US dollar, and 0.7% against the euro. The benchmark 10-year gilt yield has fallen by 35 basis points, and the more challenged 30-year gilt has seen its yield fall by 41 basis points.

While markets have reacted positively, both the pound and gilt yields have not returned to pre-mini budget levels. We do not expect them to in the near term. Given the volatility and frailty of the UK government, investors are rightly demanding a discount on UK assets to compensate for the additional risk and uncertainty in the policies they announce (and retract).

Less pressure on BoE to hike aggressively

Given the withdrawal of fiscal stimulus, the BoE will be under less pressure to raise interest rates by as much. Money markets were pricing a peak in rates of 5.5% from the current rate of 2.25%, but this has now fallen back to 4.75% following the government’s retreat.

However, we expect the BoE to remain dovish, and while it is likely to accelerate rate increases at its next monetary policy meeting in November, we forecast the BoE to raise rates by less than markets expect, potentially a peak of 4.5%. This would be helpful for households facing refinancing difficulties with their mortgages, but may result in inflation remaining more sticky in the economy.

Can Liz Truss survive?

The story may yet need a final chapter, as rumours continue to suggest that the Conservative Party may still oust Liz Truss in order to strengthen its position with the public ahead of the next general election, which must take place by January 2025. After all, the growth plan on which she based her campaign has been torn to shreds, and she has had to be rescued by a colleague from the opposite wing of the party. Even friendly newspapers are asking whether Jeremy Hunt is now running the country.

If Truss resigns or is pushed out, then the party would be wise to put forward a unity candidate or team to replace the prime minister. Further division could prompt a general election, which may require the Crown’s intervention.

Betting markets have a two-thirds probability that Liz Truss will be forced out before the end of the year. Could we yet see a fifth chancellor in five months? Investors remain understandably nervous.