Long-term Government borrowing costs surged on Friday following reports Rachel Reeves has abandoned plans to hike income taxes at her upcoming Budget.
Expectations of an income tax hike, while never confirmed, had helped ease borrowing costs over recent weeks as financial markets built confidence in the Chancellor’s ability to get Britain’s finances in order.
But an apparent u-turn on income taxes, which are seen as one of the best ways for Governments to raise money, shook that confidence.
Ten- and 30-year gilt yields – the interest paid on UK Government debt – soared 10 and 12 basis points, respectively, in early trading.
The move has undone most of the progress made to bring down borrowing costs over the last months and left 10- and 30-year yields at 4.53 and 5.35 per cent, respectively.
Sterling was down 0.5 per cent against the US dollar at around £1.131. Two- and five-year gilt yields were up 6bps and 8bps, respectively.
Change of plan: Reeves rules out income tax hike
Long-term borrowing costs are essentially a proxy for long-term inflation and interest rate expectations.
Income taxes would have been deflationary, thereby bringing down expectations for inflation and interest rates.
And it means the Chancellor will have to find other ways to fill the country’s ‘fiscal black hole’ estimated to be as large as £40billion.
This could include a further freeze on income tax thresholds, currently set until 2028, and changes to taxes on property and pensions.
Francesco Pesole, FX strategist at ING, said: ‘The gilt rally was being backed by expectations that income tax increases would have delivered the necessary fiscal tightening without stoking up inflation, ultimately allowing the Bank of England to cut rates in December and beyond.
‘So, a double positive for UK bonds: less fiscal risk plus central bank easing.
‘It’s not clear how Reeves plans to fill the £30billion fiscal hole without touching income tax.
‘For example, should she target VAT increases – an inflationary measure – a hawkish BoE repricing would hit gilts.
‘Media reports are currently suggesting a number of options being considered. One appears to be freezing the threshold for income tax brackets, which would have a similar fiscal effect as raising the rate on one bracket and could be well received by markets.’
John Stopford, head of managed income at fund manager Ninety One, added: ‘The gilt market has done relatively well over the last month as expectations have grown of credible measures in the budget to restore fiscal headroom including income tax increases as well as softer growth and inflation data supporting a December rate cut.
‘The market is likely to be disappointed with a shift back to using a list of smaller tax rises to address the fiscal shortfall, in part because this is viewed as less credible, but also because they suggest that the Chancellor’s doesn’t have the support of her party to make difficult decisions.
‘Unfortunately, there appeared to be an opportunity to create a more positive backdrop and something of a virtuous circle for gilt yields and hence borrowing costs, but this now looks likely to be squandered.
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