Reeves fights for her credibility as investors brace for leadership battle
Rachel Reeves has been left with no choice but to pursue what has been branded a smorgasbord Budget – Darren Staples/ WPA Pool / Getty Images
Like a difficult second album, the Chancellor’s next fiscal outing appears to be suffering from a lack of inspirational ideas.
Having ditched a politically risky move to raise income tax rates, Rachel Reeves has been left with no choice but to pursue what has been branded a smorgasbord Budget of smaller tax rises rather than one big set piece.
“It’s going to be full of lots of little, s—ty things,” says one insider.
Reeves has gambled that this will be less risky than breaking a manifesto pledge. But as George Osborne found out the hard way, a budget of many small tweaks runs a high risk of becoming an “omnishambles”.
When Osborne delivered his Budget in 2012, investors looked upon Britain favourably. But this time around, the bond vigilantes are in no forgiving mood.
At just over 4.5pc, Britain’s 10-year borrowing costs are the highest in the G7.
The rate charged by bond investors has broken above that paid by the US in recent months, and is more than one percentage point higher than the yield paid on bonds issued by Italy and by the troubled French government.
Reeves’s income tax about-turn triggered a fresh bond sell-off that saw yields rise by as much as 0.15 percentage points, adding billions of pounds to government debt in the blink of an eye.
While yields eased back later that day, they remain higher than where they were before.
For an idea of what’s at stake, the Office for Budget Responsibility (OBR) estimates that a one percentage point rise in interest rates adds £17bn to the Government’s annual debt interest costs. That’s half the annual Home Office budget.
In short, the cost of delivering a Budget that is poorly received by the debt market would be very high. But it is not the contents of the Budget that many investors will be watching most closely.
Matt Amis, at Aberdeen, is among those who will be watching the Nov 26 statement – and the reaction that follows.
“We’re going to have one eye on the political reaction,” he says. “While there might be a few surprises, the political noise and the leadership noise that follows is probably more important.
“It’s a bit of a Catch-22. If the Budget is good for the market, it’s probably going to be not good for the Labour Party’s backbenches. So there’ll be waiting to see what the noise is over the next few days and over the weekend, to see actually how the policies land with the Labour Party.”
Traders have already been burned by Labour’s about-turns on welfare and winter fuel payments, and so are wary of promises of jam – or in this case prudence – tomorrow.
The Chancellor has privately admitted she knows the markets are expecting a “down payment” on debt in the Budget.
Yet confidence in Reeves’s ability to do just that has been waning after recent events.
Abrdn owns £10bn of gilts but retreated from its bet on UK bonds last week after it became clear Downing Street had baulked at the idea of breaking Labour’s promise not to raise income tax rates.
One of the big issues is that for a party with a majority of almost 150 seats, they can’t seem to get anything done.
“The chaotic approach to policymaking signals less political support for difficult fiscal decisions than the market had assumed,” says Rob Wood, the chief UK economist at Pantheon Macroeconomics.
But investors are also unimpressed by the types of policies Reeves is now reaching for.
“Shelving an income-tax increase means the government will have to rely on hiking a broader range of taxes with more uncertain yields and likely distortionary effects,” says Wood.
Take the so-called bank surcharge. Many in the city are concerned that an increase in this tax on their profits will send a message that Britain isn’t open for business. Government mandarins have sought to reassure the City that any increase in the surcharge “won’t be as bad as you think”.
But many beg to differ. As one banker puts it: “I’ve told the Chancellor that any increase is not good. Don’t think we’ll just accept it and it’ll all be okay”.
Varun Chandra, Sir Keir Starmer’s business adviser, is said to be very upset at some of the major measures in the Budget.
Then there is the timeline of any tax rises.
An extension of a stealth tax freeze that does not kick in until 2028 or property taxes that are delayed will not impress a market that is expected to digest more than £300bn of gilt issuance this year alone, a number that will only fall slowly in the coming years.
“The main advantage of raising income tax rates is that it would have been implemented by the next fiscal year and we would have started seeing higher tax revenues straight away,” says Amis.
“But if higher taxes are put off until the third, fourth or fifth year of the forecast period, then that feels a lot like a Budget where the hard decisions are delayed.”
Cathal Kennedy, at RBC, says bond markets will not embrace the Budget if “too much of the plan is backloaded”.
She adds: “The Chancellor could pencil in a lower pace of spending growth in 2029-30. However, we think that the market would question the credibility of a package based on substantial tax rises or spending cuts around the time of the next election.”
One reason why borrowing costs started to fall in October, before the change of heart on income tax, is that investors started to believe fiscal prudence would pave the way for a series of interest rate cuts by the Bank of England – which would in turn ease the pressure on the public finances by keeping debt interest costs down.
The Government is determined to bear down on prices in the budget, with a mooted cut in energy bills forming one of the central giveaways.
A freeze in rail fares and prescription charges could also pave the way for social rents to be held in a move that would knock around five basis points off the headline rate of inflation. When your debt interest bill is £100bn a year, every basis point counts.
He says: “Political risk and policy paralysis partly explain why we see gilt yields remaining elevated beyond the Budget.”
Ultimately, many investors will be looking past the Budget to what happens next.
“We think the threat of looser fiscal policy – coming from a leadership challenge to Keir Starmer – will weigh on gilts over the coming year,” Wood says.
“Granted, keeping the Government’s manifesto pledge on tax buys some time,” Wood says. “But a leadership challenge after next May’s local elections at the latest seems likely, given the Prime Minister’s awful approval ratings.”
Investors are watching. Yet even a bond market-friendly Budget may not be enough to save the Chancellor and her boss.
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