investment insights
Tax cuts, the Bank of England’s response and our UK outlook
Key takeaways
- The market reaction to the UK’s new fiscal announcements was severe, but the country’s debt sustainability or the possibility of an emerging-market style crisis are not at risk. Our main concerns are overheating risks and a particularly sharp response by the Bank of England, as well as longer run institutional credibility issues
- The energy price cap should reduce the UK’s inflation peak and winter recession risks, but large tax cuts in the face of high inflation will lead to more aggressive interest rate rises. We expect outsized hikes exceeding 200bps by year-end and a peak policy rate above 5% by early next year
- In the absence of any reversal to planned tax cuts, we see further downside risk for sterling, with EURGBP eventually rising towards 0.95, and GBPUSD trading at or below parity in the medium term. Risks could even be tilted towards further depreciation.
What was announced at the UK’s ‘mini-Budget’?
The UK’s new Chancellor, Kwasi Kwarteng, announced the following on 23 September:
- Energy price cap (average of GBP 2,500 per household from 1 October, prices for businesses capped for six months)
- Additional tax giveaways likely to add another 1.5% of GDP to the deficit (scrapping top rate of income tax, planned rise in corporate tax rate and cap on bankers’ bonuses; stopping ‘green levy’ on households; reversing a rise in National Insurance that came into force in April)
- The government also pointed to further supply side growth measures to be announced in October and early November
The energy measures had already been heavily trailed in the media, but the tax cuts went beyond (already sizeable) expectations of fiscal easing. A key aspect of the announcement was that rather than financing the package by revenue increases or spending cuts elsewhere, it will be deficit financed, leading to a large increase in public borrowing over the near term.
What is more, the government did not flag up any plan for medium-term debt reduction or concerns about a possible breach of fiscal rules, nor were the measures costed up by the Office for Budget Responsibility (OBR), which provides an element of independent scrutiny. The government’s messaging on plans to finance the tax cuts was rather poor, focussing on the unproven (and we believe, rather dubious) message that they would lift growth and ultimately pay for themselves.
The market reaction was severe. Large unfunded tax cuts prompted concerns about the size of the UK’s budget and current account deficits (the latter in particular) and how they would be financed. The announcement prompted the largest two-day sell off in gilts on record, the pound hitting a record low against the dollar, and rising risk premia in UK assets, including sovereign credit default swaps.
Should we be worried about the UK’s debt sustainability, or a potential crisis?
Questions around the UK’s debt sustainability or even the possibility of an emerging-market style currency crisis are not the right framework to approach ongoing developments in the UK. The country’s debt/GDP ratio is actually lower than many of its advanced economy peers, while its average debt maturity is much longer (approaching 15 years for the UK compared to less than 10 years for all its peers). The OBR will now publish its forecasts of the impact of new fiscal measures – and any further announcements by the government – on 23 November, a welcome step, if rather late. Large fiscal packages in the past, e.g the ‘furlough’ scheme announced during the Covid pandemic or the GBP 137 billion bailout during the financial crisis did not tip the economy into a debt spiral. A floating exchange rate offers an important adjustment mechanism. A lower currency and higher yields is an adjustment process that could eventually make UK asset exposure attractive enough for foreign investor flows to increase. It is also especially relevant for the UK considering that historically the bulk of financing for the current account deficit has come from fixed income/debt flows.
Most crucially, an independent central bank is an important safeguard against an emerging-market style crisis scenario. All that being said, long-term risks to institutional credibility should be taken seriously. New Prime Minister Liz Truss said during her leadership campaign that she wanted to review the Bank of England’s mandate, and senior Treasury staff have already been removed by the new government for championing “orthodox” economic analysis. We will be watching the November fiscal statement to see if the government takes any action to bring borrowing down over the medium term in response to market concerns. We will be particularly attentive to any government action that may undermine the Bank of England’s independence, such as any push to replace Governor Andrew Bailey in response to aggressive monetary tightening to restore price stability.
What is our outlook for the UK economy and assets now?
1. Energy price cap should reduce inflation peak, and winter recession risks
The key impact of the energy price cap will be a significant reduction to the likely peak for inflation, now likely to be about 4-5% lower than previous expectations in the absence of a price freeze. Lower inflation, especially lower energy prices, will have a positive effect on real incomes, alleviating the pressure on the UK consumer that was faced with a “cost of living crisis,” thus improving near-term growth prospects. The policy response on energy may avert a recession during the winter.
The overall amount of fiscal easing is very substantial, likely to increase the deficit by over 5% of GDP over the course of 2022 and 2023. But the growth effects of the tax cuts are less clear, as the focus on higher-income households and corporates is likely to add less to effective demand. In addition, the sharp tightening of monetary policy that is likely to take place (see below) in response to a highly expansionary fiscal policy in the face of overheating concerns will slow growth further ahead. While monetary policy operates with a lag, and its full effects will not be felt before late 2023, the sharp rise in mortgage rates and the broader tightening of financial conditions will cause a material growth drag. We are therefore looking for a small net improvement in growth in 2023, upgrading our full-year forecast to +0.1% (from -0.3% previously).
2. A forceful BoE response will push interest rates sharply higher
The Bank of England (BoE) held its last policy meeting one day before the mini-Budget announcement, and has taken no aggressive action on rates yet in response.
In a split vote during that meeting, its Monetary Policy Committee (MPC) decided against a 75bp hike, increasing the policy rate by just 50bps to 2.25%. It also announced it would reverse some measures of longstanding quantitative easing, with a plan to actively sell government bonds, starting on 3 October.
Instead of holding an ad hoc meeting in response to the mini-Budget and market reaction, the bank chose to respond via a brief statement on Monday 26 September by Governor Bailey, where the key message was that the MPC “will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term.”
On Wednesday 28 September, the BoE was also forced to intervene and purchase government bonds, while postponing the start of its active sales programme to 31 October. The size of the latter was left unchanged (suggesting the later start will be made up). The intervention (on “whatever scale is necessary”) was seen as a necessary response to rising financial stability risks.
We think that large fiscal easing in the face of very high inflation calls for an aggressive response by the BoE. Having decided against an emergency hike and having launched emergency bond-buying risks raising questions about its political independence (i.e. a willingness to help the government finance its widening deficit directly by buying bonds). Sending a strong message is therefore required at this point.
Market expectations on rates have shifted up significantly after the fiscal event, with peak interest rates of around 6% now priced in. If the BoE were to significantly under-deliver on these expectations, it would be effectively easing financial conditions – adding to inflation risks. We think this will translate into outsized rate hikes in the last two meetings of this year, 125bps in November and 100bps in December, taking the bank rate to 4.5% by year-end. We expect smaller rate hikes thereafter, and rates to peak around 5.5%.
3. Further downside ahead for sterling
Coming into September, we had a bearish view on sterling (GBP), primarily driven by a deteriorating current account deficit, with a recent worsening largely linked to higher energy prices. At this point, our views did not incorporate concerns over how the deficit would be financed. In light of recent developments, we think the situation has changed and we now see further downside for the currency.
In the absence of any meaningful adjustments or reversal to the planned tax cuts, we believe that EURGBP – the cross that most embodies “trade-weighted” sterling – can eventually rise towards 0.95. This is close to the pandemic highs, and is consistent with EURGBP becoming ‘overstretched’ versus fundamental drivers that have explained developments in the currency pair. This situation also happened following the great financial crisis of 2008-09, the Brexit referendum, and during the Covid pandemic. We assume a similar level of sterling underperformance is likely going forward. It is worth emphasising here that while both sterling and the euro have fallen against the US dollar for much of 2022, for the most part, sterling has held up relatively well: EURGBP has traded in a lower 0.83 – 0.87 range for much of 2022. Hence, there is now scope for sterling to underperform. With our new base case assumption of EURGBP near 0.95 and risks that EURUSD decline to 0.95 (or below), we note that GBPUSD could eventually hit parity and trade below that level on a medium-term view.
Risks could even be tilted towards more sterling depreciation. Assuming the current energy shock keeps the UK’s current account deficit close to its current level (equivalent to 8% of GDP) and capital flows plug only part of the deficit, trade-weighted sterling would need to fall in the order of 15% to return the current account deficit to its ten-year average (4% of GDP). That would roughly translate into EURGBP at 0.98 – the high seen following the great financial crisis. A more extreme scenario of a sudden stop (where capital inflows dry up) which requires the current account to come back into balance would require an even sharper sterling depreciation (30%). We assume this is less likely, however, and hence remains a tail risk.
Ultimately, the cure for reversing the current situation of a sharply declining exchange rate would likely need to come from some adjustments on fiscal policy, with signals that appear more credible. Unilateral currency interventions are unlikely to sustainably turn around the currency’s fortunes given the large current account deficit. Sharply higher interest rates could stabilise the currency for a brief period, but will inevitably bring into question the sustainability of debt at some point, to the eventual detriment of sterling. Accordingly, the path of fiscal policy could remain the most important currency driver going forward.
At the current juncture, a preference of policymakers to anchor gilt yields (due to financial stability concerns) would imply that sterling has to do more of the heavy lifting in cheapening and, eventually, enticing, foreign capital inflows to cover the current account deficit.
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