The Budget Brings Two Competing Narratives For Gilts

Developments in the Gilt market make a lot of sense this morning, with the front-end rallying hard (benchmark 2-year yields to their lowest level since last August) amid a dovish repricing of rate expectations following the dismal jobs stats earlier.

However, I wonder whether market participants might need to start thinking ahead a little more, as opposed to simply hanging on backwards-looking, and at this point rather unreliable, labour market statistics.

Clearly, unemployment having risen to 5%, its highest level since the pandemic, is far from an optimistic sign. More doses of pessimism are likely on the cards, with the Budget now just two weeks away. A rise in the basic rate of income tax, for the first time in half a century, seems a done deal, potentially to the tune of as much as 2p, with that being a move that would not only break the manifesto promises made by the Labour party last year, but which would also – quite obviously – pose a stiff headwind to personal consumption after it was implemented.

One thing that the Budget will almost certainly not contain is any spending cuts. In fact, if anything, Chancellor Reeves actually seems likely to increase spending on 26th November, especially if paper talk about the possibility of the two-child benefit cap proves correct.

While this is all well and good, there’s an increasing high risk that, in trying to ‘thread the needle’ and concoct the Budget, the Chancellor actually ends up pleasing none of the three key constituents that she must keep onside – financial markets, Labour MPs, and the electorate.

For markets, a Budget that, as seems likely, brings no plan (or semblance of one) to cut public sector waste, and reduce government spending, is unlikely to go down especially well. This is especially true when that same Budget seems set to contain little in terms of policies to boost economic growth, but plenty of policies to stunt it, as mentioned above. That, quite clearly, runs the risk of the UK economy falling ever-further into the fiscal doom loop, with tax hikes raising nowhere near the amount of revenue that had been expected, spending continuing on an unsustainable path, and the Chancellor coming back to beg for more revenue in a year’s time.

For Labour MPs, the Budget probably won’t be much fun either. Those very MPs, it must be said, are partly responsible for Reeves being in such a bind, given not only their refusal to vote in favour of welfare spending cuts earlier in the year, but their refusal to even vote in favour of a slower pace of increase in the welfare bill. Anyway, it will nonetheless be a very tough ‘sell’ indeed to convince the electorate that, despite GDP growth actually turning out better than the OBR had expected, a substantial manifesto-breaking fiscal tightening is still necessary.

On that note, for the electorate, it’s rather self-explanatory – just as turkeys tend not to vote for Christmas, it would be unusual for the electorate to vote in favour of impoverishment. Labour already lag badly in nationwide opinion polling, with possibly the largest revenue-raising Budget ever hardly a plausible route back to a poll lead, not least ahead of local elections next May.

All this is to say that, while market participants focus on the fiscal risks, it’s probably the political risks that we should be paying more attention to.

These political risks, chiefly, take the form of a post-Budget personnel change, whereby the fiscal package is received so terribly, and the political fallout proves so brutal, that Chancellor Reeves does not survive in post – probably as, naively, PM Starmer attempts to save his own job, in such a scenario.

Who comes into Number 11 next isn’t exactly clear, though the smart money would be on it being a figure from the Labour ‘left’ – in other words, someone much less fiscally prudent, and much less likely to stick rigidly to a set of ‘fiscal rules’. A cursory glance back to July, when Reeves’s tears in the Commons sparked speculation she may imminently be replaced, and the subsequent Gilt sell-off after this moment, gives a sample of how Reeves’s possible ouster could pan out.

All in all, then, there are really 2 narratives circling the Budget. Firstly, there is the matter of plugging the £30-odd billion ‘black hole’, and the policies enacted to do so. Secondly, there is the political fallout from the choices that have been made.

While Gilts may cheer the former, they seem highly unlikely to take such a positive view of the latter. The same goes for the pound, incidentally, with the traditional inverse relationship between a currency and its yield unlikely to hold much water if/when political worries come to the fore once more.