Markets knew chancellor Rachel Reeves was planning to change the government’s fiscal rules in her Autumn Budget speech. She confirmed as much last week.
There was a fair amount of noise in the lead-up as investors questioned what this would mean for the gilt market. Critics muttered words like “Truss” and “Mini-Budget”. But the reality of this Budget was always going to be quite different.
Everyone knew Reeves wouldn’t be announcing a string of unfunded tax cuts, unlike former prime minister Liz Truss. On the contrary, she was rumoured to be raising taxes (which she did ultimately do, and to the tune of £40bn).
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Reeves was also clear that any funds unlocked by the change in fiscal rules would be invested in the UK economy – an attempt to boost long-term growth. The director of the Institute for Fiscal Studies, Paul Johnson, called this a “courageous move and a welcome focus on the long term”.
Why, then, have markets turned sour in the aftermath of Reeves’s speech?
Gilt yields rose in the lead-up to the Budget (indicating additional risk) but briefly fell while Reeves was speaking – a moment of calm that suggested previous fears might have been unfounded.
That moment was short-lived. Shortly after Reeves’s speech finished, markets cottoned on to the scale of the borrowing that would be required to meet spending plans.
Overall, the Budget will increase spending by £70bn annually with around half of this being funded by an increase in borrowing. That is equivalent to £32 billion more in government borrowing each year, according to the Office for Budget Responsibility (OBR), or around 1% of GDP. The independent body calls this “one of the largest fiscal loosenings of any fiscal event in recent decades”.
Furthermore, while higher spending will start to kick in fairly quickly, the majority of the tax revenue generated by the Budget (partly used to fund this spending) won’t be collected quite so soon.
“In fact, the OBR estimates that only £25bn [of additional tax revenue] will show up in the next fiscal year, most of which comes from the hike in employers’ national insurance,” say James Smith, Chris Turner and Michiel Tukker, experts at financial institution ING. “The myriad of other revenue-raisers will take more time to show up in full,” they add.
Gilt market and UK equities
Following the publication of the Budget, the UK Debt Management Office (DMO) announced that its 2024/25 financing requirement was increasing by £22bn to £300bn overall. This will involve additional gilt sales worth £19bn.
Higher borrowing can dampen sentiment about the attractiveness of government debt, pushing yields up. 10-year gilt yields have risen to their highest level this year in the aftermath of the Budget, at around 4.4%.
The FTSE 100 is also in the red today, down around 0.8% at the time of writing. Rate-sensitive areas of the market have been hit the hardest, as markets temper their expectations for how quickly the Bank of England will cut interest rates.
If interest rates stay higher for longer, it won’t be good news for housebuilders and retailers hoping for reduced pressures on household finances, says Russ Mould, investment director at AJ Bell.
“It also explains why banks were among the select few risers on the FTSE 100, as they stand to benefit from a stronger interest rate environment as they can charge more for lending,” he adds.
Despite this, Deutsche Bank strategist Shreyas Gopal notes that UK equities were not materially underperforming peers this morning.
“[This] suggests that overall the market is adjusting to a larger-than-expected fiscal event (and expecting a more hawkish Bank of England as a result), rather than incorporating an idiosyncratic fiscal risk premium across UK assets,” he says.
