Traders wary UK’s budget risks revving inflation

Bond investors are positioning for a potential rise in inflation if Chancellor of the Exchequer Jeremy Hunt cedes to pressure to deliver pre-election giveaways in this week’s spring budget.

Royal London Asset Management and Candriam are preparing for the prospect that mooted tax cuts could increase consumer prices, making it difficult for the Bank of England to cut rates as much as the market expects this year – and deepening a selloff in bonds.

While no one expects a repeat of the Liz Truss mini-budget debacle that roiled markets, investors are concerned Hunt may use the budget to try to rescue the Conservative Party’s political fortunes ahead of a general election expected later this year. Many in his party are calling for him to slash the overall tax burden, which has risen to its highest level since World War II.

The Joseph Rowntree Foundation on Monday said there was a “desperate need” at the upcoming budget for measures to support living standards, which they say are set for a second “lost decade.” 

“Given where the polls are, the likelihood of some kind of fiscal injection pre-election has got to be pretty high,” said Justin Onuekwusi, chief investment officer at wealth manager St James’s Place, which oversees £153 billion (S$260.5 billion) and has a market neutral position on gilts. 

Royal London is favouring long-end gilts, betting on a flattening of the curve, while Candriam recently turned neutral UK bonds from long previously. 

GET BT IN YOUR INBOX DAILY

Start and end each day with the latest news stories and analyses delivered straight to your inbox.

Sign UpVIEW ALL

Any fiscal stimulus risks further deteriorating the backdrop for UK bonds, which are already off to a bad start to the year. Traders have slashed rate-cut expectations amid worries on persistent price pressures and resilient consumer spending. A similar repricing in the US toward fewer cuts also contributed to the moves. 

At the end of last year, money markets were pricing as many as six BOE quarter-point rate cuts in 2024, with the first move in May. Now, just three such reductions are fully priced and the cycle is only seen starting in August. 

The yield on two-year government bonds, which is strongly linked to monetary-policy expectations, has risen over 60 basis points since the start of the year, the most in the developed world. Benchmark 10-year yields rose by a similar amount to trade at around 4.11 per cent on Monday (Mar 4). 

“If tax cuts and tax breaks are put in place to increase economic activity then there’s a risk that the Monetary Policy Committee will find it difficult to cut rates as much as the market expects this year,” said Craig Inches, head of rates and cash at Royal London Asset Management. 

Hunt told colleagues at a private meeting on Feb 26 that the Spring Budget will see him pursue “smart tax cuts,” which won’t be on the same scale as in last November’s Autumn Statement. That budget included cuts to taxes on work and the permanent extension of a programme allowing businesses to offset the cost of investment against their tax bill. 

In two television interviews on Sunday, Hunt tried to temper expectations for eye-catching tax cuts, saying his budget would be “prudent” and “responsible” and that he wanted to “show a path” toward a lower-tax economy. 

The chancellor is limited by his own fiscal rules that require him to ensure debt is falling within five years. The Office for Budget Responsibility’s forecasts have indicated that Hunt has about £13 billion to spare, an historically low level that gives little scope for large-scale tax cuts while still maintaining some of that buffer for emergencies. 

That’s left the government considering spending reductions to fund bigger tax cuts, a move that comes with its own political risk, given a Tory decade of austerity that’s still within recent memory. 

Still, the Resolution Foundation think tank and analysts at Goldman Sachs Group estimate the headroom could be much higher – around £23 billion – due to a record fiscal surplus. That would give Hunt the firepower to cancel the planned 5 pence increase in fuel duty at a cost of £2 billion and knock 2 percentage points off the 20 per cent basic rate of income tax, at a cost of £14 billion. 

“The modest change in the supply-demand balance at the margin reinforces our view that the BOE will likely wait until June to cut,” Goldman analysts including Sven Jari Stehn said.

Analysts at HSBC including Daniela Russell are expecting fiscal easing of about US$12 billion because “the government will want to avoid any reminder of the events of Autumn 2022.” That would have only a marginal impact on inflation, which “would not make a major impact on the BOE’s thinking.”

The central bank expects inflation to fall to its 2 per cent target in the coming months from 4 per cent currently, but officials warn it will rise again toward the end of the year due to changes in energy prices. A BOE analysis suggested the £20 billion of business and personal tax cuts in Hunt’s Autumn Statement was inflationary, though stressed the impact was small. 

“With the Conservative government likely to have a voter-friendly budget in the run-up to the elections, there is a possibility of a small resurgence in inflation,” said Philippe Noyard, the global head of fixed income at Candriam.

That has traders and market strategists alike looking to Wednesday’s budget for direction. With so much hanging on how Hunt cuts taxes – not least the outlook for inflation and path of the BOE – the statement has become a line in the sand for investors deciding how to allocate their cash.

The budget “should really help clarify some key risks for markets this year,” said Nick Rees, an FX analyst at Monex Europe in London. BLOOMBERG