UK bonds sell off after income tax U-turn
UK government bonds sold off sharply on Friday morning, as markets recoiled from the government’s decision to row back on plans to plug much of its multibillion-pound black hole with a manifesto-busting income tax hike.
The yield on 10-year gilts – the common benchmark for the government’s long-term ability to borrow – climbed by some 12 basis points at market open, after investors priced in the added uncertainty and damaging consequences of the extraordinary last-minute U-turn.
And in a further sign of market unease, the pound, which generally moves inversely to government bonds, also sold off dramatically, hit a fresh two-year low against the euro and fell some 0.5 per cent against the dollar.
“Bond market volatility is not what the Chancellor wants to see with less than two weeks to go before the budget,” said Kathleen Brooks, research director at XTB. “Essentially, the bond market is warning the chancellor that she cannot merely tax the ‘rich’ to fund her lavish spending pledges. Either she broadens the tax base, or she cuts spending.”
The twin routs follow a shock move from the Chancellor and Prime Minister Keir Starmer to walk back from a widely telegraphed plan to raise the general rate of income tax by as much as 2p to plug a gaping shortfall in the public finances.
At a hastily arranged press conference last week, Rachel Reeves hinted heavily that she favoured a broad-brush lift to the basic and higher rates of income tax over targeting dozens of different reliefs and duties.
What levers does the Chancellor have left?
Bond and foreign exchange investors had generally responded well to the Chancellor, who most economists believe needs to consolidate fiscal policy by as much as £35bn, prioritising the simpler, less distortive measure over many separate ones.
Aided by several soft economic readings and a dovish Bank of England hold this month, gilt yields had been steadily falling in the months leading up to Reeves’ statement on 26 November. Spreads – the difference between the yield on UK government bonds versus those for comparable economies – had also been shrinking.
That trend was halted after the leadership saga set off by rumours from Downing Street that health secretary Wes Streeting was plotting to dislodge Starmer as leader, and news of the income tax row-back, first reported by the Financial Times, has sent it sharply into reverse.
“Ruling out income tax rises raises the chances that the Chancellor has to resort to tax changes that are either inflationary, have severe distortionary effects, or worse, both,” Thomas Pugh, chief economist at RSM, told Morning Wire. “This would mean the damage to the economy would be greater than necessary and would put future interest rate cuts at risk. The Chancellor should put economics ahead of politics and raise income taxes.”
Kallum Pickering, chief economist at Peel Hunt, added: “If Reeves stays clear of raising income tax rates or lowering the thresholds at which they are paid, her remaining option would likely be to opt for a haphazard patchwork of smaller anti-growth tax increases. That would be a bad outcome.”