UK's budget policy could actually be a source of support for the pound

There’s been quite a turnaround from UK PM Rishi Sunak and Chancellor Hunt in the fifteen months, or so, since the disastrous fiscal experiment of Sunak’s predecessor Liz Truss collapsed the gilt market and the pound. Sunak decried Truss’s fiscal largesse, but now, with opinion polls suggesting a crushing defeat in this year’s election, Sunak is starting to mimic Truss more and more. The question is, does this imperil the gilt market and the pound all over again?

Go back six months or more, and it appeared that there was no room for significant tax cuts ahead of the election unless, that is, the economy started to magically improve. Six months on and the economy has not improved; in fact, a recession looks more likely all the time, and yet after delivering tax cuts in the Autumn Statement last November, there is speculation that another GBP10bn might be available to dish out in the March budget.

The Office for Budget Responsibility (OBR) is due to update the chancellor this week on its estimate of the fiscal ‘headroom’ that’s available should he decide he wants to cut tax, lift spending or pay down debt. Given the urgency created by an election later this year the Chancellor will undoubtedly decide to cut taxes. Opinion polls put the Conservatives behind by at least 20 points which suggests a wipe-out at the next election.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy has very little doubt that any tax cuts are going to rescue the situation. But they might have a bearing on how financial markets move between now and polling day (which has yet to be determined by the government), and how the Labour Party will have to manage the budget should it win a majority (which seems likely).

The UK government might be playing a bit faster and looser with fiscal policy than it might have led us to believe just a few months ago, but it is not on the scale of the shock caused by the Truss government. In addition, there are two other differences between now and then. The first is that the Truss government ignored the OBR in putting together its budget, and the second is that the rise in gilt yields quickly caused a crisis situation because of the difficulty Liability Driven Investments (LDI) experienced in the defined benefit pension market. If we fast-forward to today, the OBR is involved this time, and LDI vulnerability should not be a factor. Of course, this does not give the government carte blanche to cut taxes, but it might just stretch the budgetary elastic as far as it can, and that could create some ripples in the bond market at least, if not in the pound. But what sort of ripples?

In Mr. Steve Barrow’s view, when it comes to sterling, the economy’s dire position right now can hardly be a magnet for foreign investors; something that’s only too clear from the continuing underperformance of the stock market. If tax cuts can help turn this around, then budget policy could actually be a source of support for the pound and not a justification for weakness, as we saw during Truss’s short tenure. Hence, if, as seems likely, the government pulls out all the stops on fiscal policy without going over the edge, as Truss did, it is more likely to lift the pound than lower it.

A second aspect of what the government is doing is that tax cuts today are to be paid for by greater spending stringency in the future. This was the approach in the Autumn Statement and it will be applied again in the budget with two aims. The first is to goad Labour into promising tax hikes early on in any parliament should it feel compelled to reverse any pre-election Conservative tax cuts. The second is to box Labour in with respect to future spending commitments, such as the GBP28bn earmarked for the so-called green transition, or Green New Deal.

“If the government delivers tax cuts that both lift growth prospects now and reduce Labour’s room for manoeuvre after polling day then many might see that as beneficial for the pound and perhaps even beneficial for the – seriously lagging – stock market”, said Mr. Steve Barrow.