UK budget experiment tests markets

By William Vaughan and Katie Klingensmith

There’s been quite a stir in the UK Over the past few weeks, the world has been turned upside down by the historic funeral of Queen Elizabeth II. Now serious new concerns made headlines, triggering a liquidation of UK assets.

Yields on gilts are soaring and the pound is crashing, even hitting an all-time high against the US dollar (USD). What drove the huge moves in the UK currency and bond yields (see Figures 1 and 2)?

For starters, one of the main culprits is the unveiling of the government’s “mini” budget, which is anything but mini. It contains a few surprises that caught the market off guard. On the one hand, tax cuts; energy subsidies are on the other.

The market generally expected the energy subsidies, but not the magnitude of the tax cuts. The new budget provides for a significant reduction in the top tax rate, bringing it to 40%, down from 45% previously.

This decision, which will benefit the highest earners, is essentially a fallout economy on steroids. At the other end of the scale, the lowest rate gets a meager discount at 19%, down from 20%.

Essentially, these changes give top earners a significant boost to their disposable income, which is also potentially a type of inflationary measure – as the country faces high inflation, an energy crisis and a potential recession. So of course politics and communications got a little out of hand.

In addition, energy subsidies could lead to almost unlimited liability for the government. In contrast, some European governments may provide an upfront allocation – a subsidized cost – but the rest depends on the market and energy usage.

Thus, the UK’s view of unlimited liability combined with tax relief for higher earners is poor. There is a cost of living crisis in the UK which will need to be funded by increased budget spending when interest rates are already high.

After two back-to-back 50 basis point (bp) rate moves and the pound approaching parity with the USD, everyone is now expecting some sort of shock and awe intervention from the Bank of England (BoE) .

The BoE stepped in to stabilize the bond market, pausing its program of selling gilts and buying long-term bonds for a set period, but the central bank still finds itself significantly behind the curve with no meeting scheduled for a while. time.

The fact that a member of the monetary policy committee only called for a 25 basis point hike last week shows how far behind he is. Double deficits and now gilts and sterling selling at the same time put the UK in a worrying position.

Looking ahead, the government is betting big that the trickle-down economy will work, and in two to three years it will be fine. With the British pound (GBP/USD) hovering just above parity (1.0), a whole host of UK assets could become very attractive.

In addition, the UK economy is heavily dependent on Foreign Direct Investment (FDI) to finance many expenditures. Again, at some point, rates and assets will look very attractive to foreign investors.

In the meantime, the government could better communicate the supply-side reforms that are a key part of these spending programs. Instead, the tax cut for the rich grabbed the headlines.

Although the situation in the UK has captured global attention, it will likely remain a local story. With one of the lowest debt-to-gross domestic product (GDP) ratios among G7 countries, the UK government probably thought it was in a better position to introduce this type of fiscal program.

However, the market reaction, with gilt prices and the currency moving in the same direction, was a huge wake-up call to the rest of the world. As other countries face potential changes of government over the next two quarters, including Brazil, Italy and even the United States with midterm elections around the corner, it would be wise to learn from the fallout from the UK’s latest fiscal and monetary experiment. .

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.