© Reuters. People walk through the City of London financial district during rush hour in London, Britain, October 3, 2022. REUTERS/Henry Nicholls
By Andy Bruce
LONDON (Reuters) – Prime Minister Liz Truss’s U-turn on abolishing Britain’s top rate of income tax may be only a first step on the path to restoring fiscal credibility, with investors warning that the government still needs to show that it can afford its plans.
On the face of it, Britain’s financial markets look in better shape than last week, when the pound crashed to a record low against the U.S. dollar and government bonds tanked in response to finance minister Kwasi Kwarteng’s economic plans.
The BoE had to step in on Wednesday to restore order to Britain’s long-dated government bond market, which seized up when pension funds rushed to raise cash amid the turbulent market reaction to Kwarteng’s Sept. 23 “mini budget”.
While the pound edged up and government borrowing costs fell on Monday after the decision to reverse the planned cut to the highest rate of income tax, investors still had a clear message: Kwarteng must convince them that he can finance his growth plan without ruining Britain’s reputation for managing the budget.
“The answer will be clear in a few weeks’ time when the Bank of England’s emergency measures end,” said Jane Foley, head of forex and rates strategy at Rabobank.
The BoE’s bond-buying intervention is due to finish on Oct. 14.
“UK assets, the pound and gilts are not out of woods yet,” Foley added.
The worry is that wild market conditions could return quickly unless Truss and Kwarteng acknowledge that their promises of future economic growth on their own are not enough to explain how a high-spending, low-tax agenda will be funded.
Any relapse into severe dysfunction for the gilt market would pile pressure on the BoE to keep buying bonds – even with inflation close to its highest level in 40 years.
This, economists say, could open the door to full-blown “fiscal dominance”, when a central bank’s mission to control inflation is compromised by its involvement in government financing – anathema for investor confidence.
“The issue was not tax changes announced at the mini-budget but the institutional ‘scorched earth policy’ that preceded it. UK risk premia will likely only pull back if that is addressed,” said Simon French, chief economist of brokerage Panmure Gordon.
Orla Garvey, senior portfolio manager of fixed income at Federated Hermes, said last week that yields on long-dated gilts were likely to shift higher once the BoE’s intervention ends.
Others too warned that gilts still look vulnerable.
British government bonds have mostly failed to recoup the historic losses incurred in the aftermath of Kwarteng’s announcement – with the exception of the long-dated debt subject to the BoE’s support.
“We have to see what happens when the Bank of England stops buying next month. It’s just a sticking plaster,” one pension fund manager told Reuters last week.
Kwarteng hopes markets stay calm enough to allow him to wait until Nov. 23 before announcing his next budget plans. Unlike his mini-budget, they will come with forecasts for the economy and the public finances from Britain’s budget watchdog.
Truss has repeatedly blamed Britain’s market crash on global financial conditions.
While bond prices for many governments have fallen sharply in response to rising U.S. interest rates, in September 10-year British gilts suffered their steepest calendar-month loss since at least 1957, according to a Reuters analysis of Refinitiv and Bank of England data.
It was also the heaviest fall for any Group of Seven country’s 10-year bonds since 1987.
One cabinet minister, Simon Clarke, said in an interview with The Times on Friday that the worst of the market anxiety had passed. But economists, including those from major U.S. banks, are not so sure, even after Monday’s U-turn.
“The key question now is whether this signals a broader change in tack with respect to this government’s fiscal approach,” analysts at U.S. bank Citi said. “Markets are yet to be convinced.”
The slump of Truss’s Conservative Party in opinion polls “is likely to add to the pressure for the PM to (change) course, especially given the initial weakness of Truss’ position,” they said in a note to clients.
If the government fails to calm markets, the pressure on the BoE is likely to build as the Oct. 14 end-date for its emergency bond-buying approaches.
“If the Bank resists fiscal dominance and does indeed stick to its mandate, the pound should stabilise – but the costs will be substantial,” said academic economist Jonathan Portes, senior fellow at the UK in a Changing Europe think tank.
In this scenario, which could see the BoE raising interest rates sharply, homeowners, businesses and public services would bear the cost of Kwarteng’s tax cuts.
“But if it doesn’t, the pound will continue to fall, and inflation will stay higher and longer, and the UK will become a steadily less attractive place to invest,” Portes said. “Again, we will all pay the price.”