U.K. Market: Growth, But at What Price?

The U.K. government announced a new fiscal package last week and, while most of the measures were expected, the market has reacted fiercely. The situation remains fluid, and the outlook will largely depend on the future monetary and fiscal policy mix. While we expect a credible monetary policy response from the Bank of England (BOE), U.K. financial market volatility is likely to remain high.

What did the government announce?

The government confirmed that it will cap energy bills for households and businesses. It will also cut National Insurance (a form of income tax) from November this year and cancel the planned hike in corporation taxes. But the government also announced some unanticipated measures, including broader tax cuts. From April 2023, the government will cut income tax: the lowest marginal income tax (basic income tax) by one percentage point, and the highest marginal income tax (additional rate) by five percentage points. It will also cut stamp duty, a transaction tax on house purchases.

The fiscal package is large, but the extra unanticipated easing was fairly modest, in our view. The energy package looks to cost around £90 billion per year, but this could rise up to circa £120 billion if the government extends the business package for a year. The anticipated tax cuts appear to be worth around £30 billion per year, while the unanticipated tax cuts appear to be worth about £10 billion per year.

Taken together, the package will likely be worth 5%–6% of U.K. GDP in the first year and could add about 1.5% of GDP to the long-term deficit. Debt relative to GDP now appears to be on an increasing path, not least because long-term interest rates now exceed the underlying trend GDP growth.

How did markets react?

The market reaction has been ferocious. Some of the market moves – e.g., front-end yields rising – are consistent with the traditional effects of stimulative fiscal policy and a robust and credible response from the BOE. But other market moves – long-end yields rising initially, the currency weakening, and risk assets falling – suggest a loss of confidence in the fiscal anchor and/or concern in the ability of the BOE to deliver on its inflation mandate. It seems that the market is digesting the overall size of the fiscal package and becoming more concerned about debt sustainability. This is in part due to the government’s language, but also because the Office for Budget Responsibility (the independent fiscal watchdog) did not produce a forecast. Market technicals may also have led to an overshoot: While liquidity for U.K. gilts has been poor all year, it has deteriorated further since the budget announcement (around 20%–30% worse in the past week, according to our liquidity metrics).