UK: Mini budget, maxi risks

The ‘mini-budget’ announced on Friday, by the UK’s new Chancellor of the Exchequer, Kwasi Kwarteng, marks a regime shift away from the fiscal cautiousness that has prevailed in recent years including under Kwarteng’s predecessor, Rishi Sunak. The focus of this mini budget was lower taxes for households and corporates, with the aim to re-energise business activity (and ultimately tax receipts). The Institute for Fiscal Studies says the tax cuts are the biggest in the UK since 1972.

The UK government has also unveiled an ‘Energy Price Guarantee’ designed to cap spiralling energy costs for households and businesses. This measure could potentially cost GBP150 bn, although it hopes to keep that off-budget. To help pay for these measures, the government has raised its annual debt issuance plan by a substantial GBP 72bn (to GBP 234 bn) in fiscal year 2022-23. 

Gilt yields spiked and sterling sank to record lows on Friday as financial markets expressed their concerns about the step-up in borrowing needs and the risk that the Bank of England may have to tighten policy even more than anticipated, causing even more pain to the economy in 2023. 
Compounding the funding pressure on the government, the Bank of England announced at its latest policy meeting that it would sell GBP 80bn of its gilt holdings over the next 12 months, even as it raised the bank rate by another 50bp to 2.25%. In other words, the market has been expressing some anxiety about the risk the UK falls into a negative macroeconomic equilibrium. We are raising our forecast for the terminal bank rate to 4.0% (from a previous 3.25%), although we do have some worries that the ongoing erosion of the Bank of England’s credibility may push it to tighten even more. 

We expect UK gilt yields to move higher across the curve and the yield curve to flatten further, with the 10-to-two-year slope moving further into negative territory. Hence, we have decided to revise our year-end forecast for the 10-year UK gilt yield from 2.8% to 4.2%. We remain underweight UK gilts.We also remain cautious on sterling as a loose budget stance will compound the UK’s current-account vulnerabilities. While potentially overblown, the rising concerns about a balance of payments crisis suggest that sterling should best be avoided in the short term. It could take a very hawkish Bank of England to support sterling. But given already very high market expectations for the bank rate in 2023, the central bank may find it hard to get “ahead of the curve” again.