As the Chancellor has walked back from a proposed increase in income tax rates (while reducing NI at same time) the budget is now expected to be less disinflationary and revenue raising measures less uncertain: income tax rise would have produced more upfront fiscal drag and the revenue would have enabled the Chancellor to directly reduce inflation through a reduction in VAT and green levies on energy bills. The piecemeal plans on the table to raise revenues are more backloaded and less certain, which has increased the “term” or risk premium on UK government debt and placed downwards pressure on Sterling. Larger changes to narrower taxes could also harm the economy through their distortive impacts on consumer and business behaviour.
While debt-crisis concerns raised by some commentators are a little farfetched, UK yields are vulnerable to sentiment, and the Chancellor will need to deliver credible fiscal consolidation plans with regards balancing revenue and day-to-day spending. Should the chancellor rebuild more headroom than the market expects, this could see a rally in long-end gilt yields. However, the major broad revenue raising levers off the table, this might be hard to deliver. If revenue raising measures delivered in budget are seen as credible and disinflationary, we might expect to see gilt yields and sterling move lower, as markets start to price in rate cuts and a reduction in term premia. If the measures lack credibility, we might see yields rise via an increase in term premia, while sterling declines at the same time – this combination could be interpreted as the markets not giving the budget pass marks.
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