News & Analysis

Newly appointed Chancellor Jeremy Hunt today announced plans to raise a further estimated £32bn in tax revenue relative to the mini-budget projections in order to stabilise concerns in the bond market over the government’s fiscal sustainability ahead of the October 31st budget statement.

Understanding that the Bank of England was now absent from backstopping stresses in the UK bond market, and that the Prime Minister couldn’t sustain another week of pressure from financial markets, Hunt took the proactive steps to trim the government’s proposed spending measures further today following Friday’s reversal in corporation tax cuts. The latest measures include: shortening the UK’s universal energy support measure (Energy Price Guarantee) to April 2023, indefinitely scrapping plans to lower the basic rate of income tax to 19%, reversing the 1.25% cut in dividends tax and the planned freeze on alcohol duty taxes, and re-instating VAT on shopping for non-UK visitors.

While the measures saw bond traders trim near-term expectations of the Bank of England’s hiking cycle and risk premia across the whole of the gilt curve, the reaction in the rates market has arguably reached its limits.

This is because the nasty growth-inflation outlook that the BoE faces has only changed its composition instead of fundamentally improving. Now, with the energy price guarantee expected to run until April 2023, the same time as the Ofgem energy price review for Q2, the BoE has returned to facing a more prolonged inflation shock that still requires a high terminal interest rate and an extended period of restrictive policy. However, the steps taken have afforded the BoE more time as foreign investors are arguably in less of a immediate need for higher risk premia and, should consumers adjust spending patterns accordingly under the less extensive energy price guarantees, there is less urgency to weigh on consumer demand to mitigate second-round effects. This has seen the BoE’s implied rate path fall for year-end fall from a peak of close to 5% after the budget was announced to below 4% today – suggesting just 175bps of hikes over the coming two meetings. Comparatively, the May 2023 implied rate remains north of 5%, highlighting the need for the Bank to continue hiking into the upcoming recession.

Year-end interest rate expectations tumble by nearly a percent from the post-budget peak but remain incredibly restrictive into 2023

Despite today’s measures, we still expect the BoE to hike by 100bps at their November 3rd meeting in order to mitigate any further inflation de-anchoring and to underpin investor confidence.

The main result of today’s measures is that we now see the financial market implications of any under-delivery as less substantial given the economic outlook will now be more forgiving to a less front-loaded hiking cycle. However, 75bps will be seen as the minimum for the Bank’s next hike, especially as inflation expectations as per the Bank’s latest Decision Makers Panel survey are at risk of becoming unanchored.

In terms of FX markets, while the latest measures have prompted a risk rally due to the impact lower Gilt yields are having across core markets, which is culminating in the pound sitting close to a percentage point higher this afternoon, we are hesitant to alter out bearish near-term forecast.

This is for two reasons. Firstly, the heightened level of political volatility continues to weigh on investor confidence measures, and it shows no signs of easing as of yet. Secondly, the pound’s fundamental outlook–which consists of higher interest rates, a protracted recession, and still high inflation rates–remains weak and will leave the pound exposed. Instead, the steps taken by the Chancellor today has merely extended the time frame in which we expect 1.05 to be reached from this month to Q4 as a whole.



Simon Harvey, Head of FX Analysis
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