‘We were elected because, for the first time in almost two decades, people looked at us – looked at me – and decided that Labour could be trusted with their money’. – Rachel Reeves, Chancellor of the Exchequer
 

But can they be trusted? 

A ballooning black hole – it keeps getting bigger every time I open the newspaper…surely it cannot keep getting bigger forever? A plan to raise taxes: but which taxes can they raise without breaking manifesto pledges and tight fiscal rules? And, tantalizingly trolling for the Trussites, lots more borrowing! But it’s borrowing for investment so it doesn’t count, right? 

The Black Hole  

Black holes can increase in size by accreting matter, such as by swallowing stars that get too close, or by merging with other black holes. 

I read that on Google. Sounds rather like Labour’s fiscal black hole, doesn’t it? It keeps getting bigger and it appears this will provide cover for raising taxes and squeezing the middle classes until the pips squeak for years. 

First it was £22bn, which then became £40bn and then rose to a whopping £100bn.  

Taxes 

Business taxes will rise, but which and how?  

Borrowing 

The government could use the Budget set piece to amend debt rules to free up spending and, implicitly, borrowing, as we detailed here. 

It was on September 23rd that the Chancellor, Rachel Reeves, promised the fiscal event of October 30th would be a ‘Budget for investment’. Labour has spent a lot of time, and no small amount of political capital, on showing it will be credible on finances.  It’s also floated a lot of test balloons to see what will work. And it’s promised pain. 

There are various ways borrowing for investment can be done, but it boils down to switching the measure of debt. The manifesto pledged to keep the rule that debt must be falling as a share of the economy by the fifth year of the forecast.   

For example, this could mean switching from the last government’s target of public sector net debt excluding the Bank of England (PSND ex BoE) to other measures such as public sector net worth (PSNW), or public sector net financial liabilities (PSNFL). We don’t need to go into the specifics of these measures. 

Previous Treasury modelling suggested that an increase in borrowing of 1% of GDP might increase interest rates by between 50 and 125 basis points, depending on economic conditions. An extra £50 billion of borrowing in 2028–29 (roughly the amount of extra ‘headroom’ provided by a switch to PSNFL) would amount to around 1.6% of GDP. More borrowing would produce an effect on the gilt market – the question is how much.  

To underline the limited scope the government has, UK public sector borrowing increased in September above official forecasts. Borrowing rose to £16.6bn in September, £2.1bn more than in the same month last year.  

Gilts 

Talk was doing the rounds that gilt yields were on the march and spreads widening due to fears about more borrowing – uncosted to an extent in that the case has not (yet) been made for the return on investment (this is key).  

In an FT interview, Reeves suggested “five years is obviously the maximum”’ for balancing the budget. The market kind of thought (rightly?) this implied unbalanced budgets and loosening of any kind of fiscal restraint that the bond vigilantes would notice. 

Laurence Mutkin at BMO talked about the possible effects on gilts in a note dated October 8th. 

He said that “…whether Reeves delivers a tighter or looser path of borrowing can move the 2y2 rate by dozens of basis points, as the market re-prices the resultant expected path of Bank Rate”. (BMO uses the 2y2y forward rate to show where the market judges the policy rate to be going) 

He continued: 

• If she delivers even modestly lower borrowing, as Hunt did at his 2023 Autumn statement, we can see 2y2y falling to around 3.0%, as it did then, on expectations of a faster trajectory of rate cuts.
• If she delivers an increase in government borrowing, the smallest rise in 2y2 we can see would be to 4.0%, the level it reached after Hunt’s fiscally lax budget in Spring 2024, to price in a slower trajectory of rate cuts.

Munster is not saying that Reeves will force up gilt yields, but the risk is worth watching. “Chancellor Reeves’ commitment to fiscal discipline at the upcoming budget is in doubt,” he writes. “This makes the near-term risks around gilts much more balanced and headline-dependent – even if ultimately, she does deliver fiscal restraint.” 

Since then, things seem to have calmed down a touch –  following a notable widening in UK-US spreads, the benchmark 10yr UK gilt now yields less than its US counterpart; ie the spread has reinverted to about -7bps from about +25bps at the start of October – so much for the UK gilt market showing stress the Budget. A decline in CPI inflation to 1.7% helped a lot. And, to be fair, this is much about the US fears as UK calm – markets think that a Trump win is a) increasingly likely and b) going to be bad for bonds.  

Political choices 

The problem is that even if you tweak the debt rules and adjust the definition of debt, it will have a material impact on both the market and policies. How you go about changing the rules will affect how much money you have left over. The IFS Green Budget notes that more money is needed. 

Ben Zaranko on X: “The cost of ending austerity depends, obviously, on how you define austerity. We reckon that at an absolute bare minimum Rachel Reeves will need to find an extra £14bn by 2028/29. Want to avoid real terms cuts to services? £30bn. Want to avoid cuts as % GDP? Closer to £50bn. https://t.co/fvkxPXGC2t” / X 

And it’s not just about waving a borrowing-to-invest magic wand. 

The IFS pointed out: “Importantly, if the government wants to relax its debt rule to allow for more borrowing for investment, it is not enough to justify this on the grounds that ‘investment is good’. It also needs to explain why we should be borrowing to pay for it. If the government believes more borrowing is the best – or perhaps even the only – way to get to net zero emissions and that failure to do so would be more costly than a rising debt path, it should make the case for this explicitly, rather than hiding behind a ‘technical’ change.” 

Hiding behind a technical change may excite bond vigilantes, but for the time being the market has calmed down ahead of the Budget.  

Securonomics? 

A big adjunct to the Budget is likely to be focused on Reeves’ flagship ‘Securonomics’ agenda. This involves giving workers more rights, at the cost of employers. The government’s own economic analysis of the Employment Rights Bill indicates it will cost businesses £5bn a year. This is not a small amount of money and will come on top of other tax changes, such as a rise in employer national insurance contributions. 

Business groups are raising the alarm – I’d anticipate this to be negative for growth. And with changes to inheritance tax, pensions tax free limits and the like, it’s hard to make a case for the Budget being good for animal spirits or UK equities. A potential hike to taxes on founders selling their businesses would be a major barrier to growth. 

Investors have been pulling money out of pension pots due to uncertainty ahead of the Budget; will they be rushing the exits afterwards?
 

Neil Wilson

Chief Market Analyst at Finalto

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