Here We Go Again With UK Fiscal Fears

Déjà vu vibes here in the UK this morning, as Gilts sell-off across the curve, sterling slides against most major peers, and confidence in the fiscal stewardship of the economy wanes even further (if that was possible).

There has been little by way of fresh concrete information on the fiscal front in recent weeks, though that in itself is hardly worth cheering, as the backdrop remains a fragile and worrying one. The ‘black hole’ continues to deepen, with Chancellor Reeves likely now needing to find somewhere between $30-$40bln of increased revenue or spending cuts in the autumn Budget to restore fiscal headroom to its spring level. Meanwhile, the growth backdrop remains anaemic, and inflation continues to rise towards a likely 4% peak in the autumn.

How does this all get fixed? Frankly, there are no easy answers.

• Further tax hikes are inevitable, though we’re at the stage where they’re almost certain to be counter-productive
• Cuts to government spending are sorely needed, though likely won’t obtain a majority in the Commons, and thus not be delivered
• Even greater borrowing, or a relaxation of the fiscal rules, would make the latest episode of Gilt market turmoil look like a ‘storm in a teacup’

So, how can the Government get a grip of the situation? It’s drastic, and the political environment right now isn’t conducive to it, but here’s my five step plan:

1. BoE End QT – While intentions were good, there is now little-to-no upside to the BoE continuing to run down the size of its balance sheet, especially when the ‘Old Lady’ is still actively selling down its Gilt holdings. This not only results in the BoE (& HMT, by extension) crystallising losses on the portfolio, but also exerts significant upwards, and unnecessary, pressure on the long-end of the curve, especially when the monetary policy implications of QT are minimal
2. DMO End Long Gilt Sales – Demand has been shifting away from the long-end of the curve for some time now, as DB pension schemes wind down, and discretionary participants such as hedge funds and investment firms demonstrate greater price sensitivity, and show little-to-no desire to fill the void at the long-end. While the DMO have been actively reducing the WAM of Gilt issuance for some time, we’re now at the stage where sales of long-end Gilts should, temporarily at least, be halted, in order to further relieve upward pressure on long-end yields
3. Reeves Out – The Chancellor’s position in Number 11 has been unsustainable for some time now, given Reeves’s apparent inability to escape the fiscal ‘doom loop’ within which the UK is trapped. The ‘government by spreadsheet’ Spring Statement showed how Reeves is no longer able to take fiscal decisions with any discretion, while market confidence in Reeves’s position was eroded some time ago. A replacement must come from outside of HM Treasury, in order to properly provide a ‘fresh start’ from a fiscal perspective – Wes Streeting, or Yvette Cooper, could get the call up.
4. Acknowledge Unsustainable Welfare State – Again, politically unpalatable, but necessary. The Government must recognise, and ensure that the UK population at large acknowledge, that the current modus operandi of an increasingly large welfare state, funded by increasingly high taxes, is simply unsustainable, and results in the fiscal trajectory deteriorating day-by-day.
5. New Chancellor Bites The Bullet – Reeves’s replacement, following the above, must then ‘bite the bullet’, and force through sizeable spending cuts, in whatever manner necessary for them to obtain a majority in the Commons, setting aside concerns over another backbench rebellion, and ensuring that the restoration of fiscal headroom is obtained by slashing expenditure, and not by moving even further to the wrong side of the Laffer Curve via another round of punitive, and ineffective, tax increases.

While the above mix would make for a rather downbeat, and volatile, few months, it seems the only way in which the UK can finally move away from the short-sighted ‘sticking plaster’ approach to balancing the books which has been taken for the last 18 months, once and for all returning the economy to a more sustainable fiscal footing.

In the meantime, however, and if drastic action is not taken, it seems highly unlikely that the trajectory for UK assets will change any time soon. To be clear, that means further pressure on long Gilts, and further pressure on the GBP as well, with recent gains having been built on foundations of sand.