Thoughts on the fallout

Scattered post-budget reflections

Watch Gilts & rates rather than the currency

With inflation where it is, a weaker pound is deeply unhelpful. It risks adding to imported cost pressures. But what is happening in the gilt and rate markets matters a lot more.

Sterling staged an impressive intra-rally yesterday from mid-morning until late afternoon as markets moved to price in much more aggressive hikes from the Bank of England – some of that rally later unwound when the Bank’s statement was taken(fairly) to be pretty weak sauce.

Stable sterling at the cost of Bank rates hitting frankly implausible levels is not to be welcomed.

The gilt market (the market for government debt) had two days of utter carnage on Friday and Monday as markets moved to price in Bank rate leaping to around 6%. To be absolutely clear: the British economy cannot cope with a Bank rate of 6%. It would crash household incomes, crater growth and drive a deep recession.

Samuel Tombs @samueltombs

If mortgage rates rise to 6%—as implied by markets’ current expectations for Bank Rate—the average household refinancing a 2yr fixed rate mortgage in the first half of 2023 will see *monthly* repayments jump to £1,490, from £863. Many simply won’t be able to afford this (1/2)

We are currently caught between a rock and hard place. Either the Bank follows through on hiking rates to frankly ridiculous levels… or it doesn’t and sterling falls again adding to imported inflation.

The third, benign, possibility is a change in the risk premium currently attached to UK assets. That is possible, but would require some shifts in the government’s current approach and a big dose of good luck.

My own base case now is that the Bank is going to hike aggressively although not as aggressively as the market priced in yesterday afternoon.

These things don’t move in a straight line

This isn’t news to many Value Added readers, but it is worth keeping in mind at a time when most of British politics twitter seems to be sharing intra-day Bloomberg charts. These sorts of things play out over weeks and months with some days – and indeed hours – being more dramatic than others. After two days of heavy selling pressure Sterling is, at the time of writing, enjoying a bounce. That doesn’t mean the situation has changed.

There are immediate real world consequences

It’s all too easy to sometimes assume that this sort of financial volatility does not impact on ‘real people’. That’s rubbish. We are already seeing disruption that will be followed by a meaningful re-pricing in the mortgage market.

And as Toby Nangle has noted these sorts of moves will lead to tougher stress tests for a range of institutions in the future. This stuff matters.

Toby Nangle @toby_n

If all these moves magically reverses over the next few days (ahem) they are STILL going have serious effects on stress tests for years and years to come. Your 'stress scenario' of +150bps over 3mths may have looked reasonable. No longer. You can't unburn toast.

November? Really?

The HMT and BOE response – ‘we’ll get back to you in November’, looks quite punchy. Maybe the markets will indeed tolerate another six or eight weeks of uncertainty.  But there is an advantage to responding quickly.

There is also an advantage to not spending the weekend after a sour market reaction talking up how you have ‘just got started’ and briefing out your next round of tax cuts to friendly papers. Hopefully that lesson has now been learned.

Get ready for the Plan for Growth Part Two: Spending Cuts

Whilst November feels fairly lackadaisical, it is already an acceleration. The Treasury’s statement yesterday represents a shift from Kwarteng’s FT interview on Friday. The timetable has been brought forward.

There are two things to note in the statement.

First:

As the Chief Secretary to the Treasury set out this weekend, the government is sticking to spending settlements for this spending review period.

Given inflation is running at about 10% compared to an estimate of 4% when the current spending package was drawn up, this implies a tight real terms squeeze for government spending.

And then there’s this:

He will then set out his Medium-Term Fiscal Plan on 23 November.

The Fiscal Plan will set out further details on the government’s fiscal rules, including ensuring that debt falls as a share of GDP in the medium term.

In the Growth Plan on Friday, the Chancellor set out that there would be an Office for Budget Responsibility forecast this calendar year. He has requested that the OBR sets out a full forecast alongside the Fiscal Plan, on 23 November.

A lot depends on the definition of medium term here. But I don’t see a route to having debt/GDP falling in year 5 (the usual period HMT have used) without plugging in large spending cuts in years 3-5.

A cynic would note that years 3-5 fall after the expected date of the next general election.

The wider agenda

The government is keen to argue to that the tax cuts shouldn’t been seen as a demand stimulus but as part of a wider supply side agenda.

Maybe.

I’m certainly prepared to accept that cutting marginal rates will have some impact on the supply side. But such impacts take years to show up. In the short term the demand side impact of the tax cuts matters more (and of course that is muted as much of the benefits are going to people with lower marginal propensities to consume, i.e. richer households).

There is a theory that by starting off with a lot of red meat for her more right leaning backbenchers on tax, Truss has bought herself the political space to press on with some supply side reforms – notably on planning – that they have traditionally opposed.  

For me the jury is out. Serious planning reform to speed up infrastructure projects and house building would be an excellent development. But I worry that those opposed to such measures within the Conservative Party will simply bank the tax cuts and give very little ground. The Party being so far behind in the opinion polls will not add to Truss’s political capital.

A serious agenda of supply side reform means doing things rather than talking about them. The best approach now is to wait and see, to hope for a positive surprise but to assume very little real progress.

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