Do we really want higher taxes and spending cuts?
November 16, 2022
TPP MIDWEEK COMMENTARY:
Let’s talk about The Autumn Statement, but not in a boring way.
On Thursday Jeremy Hunt will deliver his fiscal statement and I think what we are about to see from the UK government is a sneaky example of ‘A good day to bury bad news’.
The whole country seems obsessed with this ‘hole in the budget’ that has suddenly appeared, and much of this hole is being blamed on the mini budget but how accurate is this?
In short, not very.
If you ask someone on the street where the hole in the budget has come from then they will no doubt blame Liz Truss and say we are all paying for her mistakes. ‘The markets’, as everyone likes to generalise, didn’t like the budget and costs for households have spiralled on the back of it.
The truth is there was a temporary increase in the cost of borrowing after the 23rd September mini budget, but that increase has completely evaporated and borrowing costs are now actually less than they were on the 22nd September.
Therefore, the mini-budget can now no longer be blamed for anything at all.
As we have pointed out before, government debt market is a market like any other. Traders buy and sell. If you announce to a trading floor that you are about to sell £72 billion worth of debt (as the mini budget suggested), then any buyers in the room are now sellers. That’s all that happened. Traders only have one goal, and that’s to make money so don’t tell them what you’re about to do.
As a government debt market maker myself for a while, I can tell you exactly what my response would have been to that announcement: sell every penny of debt I own, go short the market, and then sit and wait for the government to try and sell me and the other traders a fresh £72 billion worth of bonds. Easy money.
The first move in prices happened instantly. Market makers and prop traders would have sold everything they could. This would have seen the market in freefall. Normally there would be a two way bid/offer spread for people to sell to, but that would have disappeared as there would only be sellers in the market which would exaggerate the price movement (which is what you want if you’re a trader and you’re now short).
What happened next would have caught everyone with their pants down (for the want of a better expression). The government said they were no longer going to sell and there wouldn’t be £72 billion worth of gilts hitting the market after all.
This sent the sellers into a buying panic as they were counting on being sold a huge amount of paper that now won’t exist. In fact instead, the Bank of England stepped in and bought a load!!!
The selling never happened so the market jumped back up to where it was and then a little higher as everyone scrambled to buy back.
Both of these moves happened and none of it was because the ideas in the budget were bad ideas, it happened simply because they told a bunch of traders what they were going to do and there is no easier way for a trader to make money other than knowing what is about to happen.
But it never happened, so the ‘order’ that was restored by Jeremy Hunt, was actually just someone telling the market that the debt they thought was about to come their way, wasn’t, so they had to buy everything back again. Don’t be short if there are no more sellers!
On the back of it, the whole country started calling for tax increases and spending cuts. Surely that’s a government’s dream. The public actually wanting higher taxes! Because it’s better for the economy!
Some people out there, who must have missed the first 9 months of the year, are now blaming the mini budget for the ‘cost of living crises’!!
Mortgage rates go up when interest rates go up. Gilt yields go up when interest rates go up and have been increasing gradually since the end of 2021 as inflation started to ramp up. Interest rates are what the Bank of England uses to counter inflation, so it is predicted by the (debt) markets that when inflation starts to rise, so will interest rates and therefore, so will gilt yields. Here is the 30 year chart from the end of last year.
You can see the spike on the graph above that occurred on the announcement of the mini-budget, but can we blame that for a move that clearly started in December 2021?
You will also notice that the 30 year yield was 3.76% on the 22nd September, before the statement, and it is now 3.42% which is actually below that. So if the yield is lower now, how can we blame Liz Truss for a ‘hole’ in our finances? Yes, the yield would be a lot higher if the mini-budget had been passed, but it wasn’t so we should all move on as the gilt market has. Traders don’t care about anything other then the price, and how to make money from it. ‘THE MARKETS’ have clearly moved on, so should the newspapers.
This brings me back to my comment that it will be ‘A good day to bury bad news’. Never before has a country actually wanted higher taxes and austerity, but Hunt and Sunak know they can get away with it because everyone is blaming Liz Truss and Kwasi Kwarteng!
So what is this ‘hole’ anyway?
Journalists seem to rather skate over the definition of a fiscal or budgetary hole in most of their pieces. Maybe they don’t know where it’s come from, maybe they don’t care. Maybe they also assume it’s because of the mini-budget.
The ‘hole’ is not to be confused with this year’s budget deficit, nor the level of public debt. Gemma Tetlow, chief economist at the Institute for Government, another think-tank, said that at its most basic, the fiscal hole represented “the gap [in the public finances] between where we are projected to be and where we want to be”.
That means the hole depends on the chancellor’s own definition of sustainable public finances. In short: we made it up.
We want public debt to be going down, but it’s going up. But then it always goes up. Once again I get a chance to post my favourite screenshot which shows the country’s national debt:
Before you panic too much, don’t worry, this isn’t a specific problem for the UK.
Here is France’s national debt:
Hunt has said that he wants public debt to be falling as a share of gross domestic product, and he is expected to give himself five years to meet that target (pretty sure he won’t be in that job for 5 years but let’s not dwell on that).
Ultimately, there are two factors involved in achieving this goal and therefore two rather obvious problems.
1. Interest rates are rising and that increases the cost of the debt, therefore the debt is increasing quicker not slower.
2. We are about to enter, if we aren’t already in, a recession. During this time GDP falls therefore our debt to GDP ratio can only go up.
So we have rising debt costs, falling GDP and a chancellor who would like the opposite. Good luck with that. No wonder he’s spotted a ‘hole’.
To hit his target he is examining tax rises and spending cuts worth about £55bn a year by 2027-28, which would serve to reduce public borrowing and in turn cut the debt burden. As part of filling the ‘fiscal hole’, the chancellor is likely to want to build in some room for error because forecasts for public finances are uncertain.
What factors have actually contributed to the UK budgetary gap?
Since the Treasury’s Spring Statement in March, almost everything that could go wrong has done so. New forecasts by the UK fiscal watchdog due to be published alongside the Autumn Statement are expected to cut economic growth because high energy prices make a country like the UK, which imports fossil fuels, poorer.
On top of this, high inflation and interest rate rises increase the cost of government borrowing and welfare benefit payments compared with the March forecasts by the Office for Budget Responsibility. The third issue is the government’s decision to spend tens of billions of pounds more on support for households’ energy bills, putting further pressure on the public finances.
So the biggest contributors to the fiscal hole are higher interest rates on government borrowing, a slowdown in the expected growth of the economy which would depress future tax revenues and high energy prices. The good news is, the last of these, while still historically high, does seem to be coming down.
The main reason for the panic, is that the government’s average borrowing cost has gone up from below 1 per cent at the end of last year to 3.4 per cent this week. The vast majority of this increase reflects global forces and is through no fault of our own despite what we keep telling ourselves. Bear in mind this is the cost on NEW borrowing, therefore we need to try and limit new borrowing when costs are high.
At this point we would also like to point out that the UK’s borrowing costs haven’t increased any special amount compared to the rest of the world. In fact, here are 10 major countries 10yr yields. We always like to make out that we’re the centre of all disasters, but as you can see, this is not the case.
One thing of note here is the increase in the cost of debt for Italy, Greece, Portugal and Spain. We don’t have to go back that far to recall the debt crisis that hit Greece in particular. There were bailouts galore but low interest rates managed to kick that can down the road.
Well, I’m afraid that can is back. The next issue we’ll have, is not our own debt crises but that of Europe’s………again.
In Thursday’s Autumn Statement Jeremy Hunt needs to demonstrate sustainable public finances, credible policy measures, and borrowing and debt that will be resilient to some further economic shocks.
I’m sure he will do a fine job of it, and we can carry on as we were. We absolutely do need to get a grip on public finances as this level of borrowing cannot be sustained forever, but I have been saying this for the last decade. If this is what causes us to regain control, then so be it.
He will try to strike a balance between tax increases and spending cuts. It is almost certain that he will opt for the relatively easy options of allowing inflation to drag people into higher tax brackets, rather than putting up rates, and cutting some investment expenditure — scheduled to be at historically high levels — instead of squeezing public services too much.
Those are in the bag, but will not be enough to reach his target so it will be interesting to see where the rest comes from, and how he can justify it during a ‘cost of living crisis’. As we said at the beginning though, the country called for stricter measures after Liz Truss attempted to deliver on a ‘growth package’. It turns out that wasn’t what we wanted; we want austerity and now we shall have it.
The UK’s central bank thinks a recession is needed to tame inflation and they are probably right. A recession doesn’t have to be that painful and there is no need for it to be deep, so long as companies do not seek to push prices up excessively and workers moderate pay demands.
In this scenario, by the next election (which has to be called by late 2024) inflation will probably be under control and there may be scope for a period of faster than normal growth. Front-loading the budgetary repair job would have been the necessary step, instantly making UK economic policy credible.
But who knows what problem that we don’t know about is round the next corner?!
This generalisation is starting to get annoying. ‘The Markets’ do not all like tax hikes as everyone, including the FT seem to think. Equities will not do well from higher corporation tax, or higher National Insurance, or tighter monetary policy or windfall taxes, OR ANY TAXES OR AUTERITY MEASURES.
The markets as most of us know them, will actually suffer from this statement.
Only the gilt market (which seems to be fascinating the country at the moment) could make further gains as the price of gilts would rise slightly, which is good if you’re the seller (the government), but won’t make much difference to the rest of us.
The pound might strengthen slightly, which is only really useful if you’re planning a holiday to America.
Once again we have been beating ourselves up about how rubbish the pound is. We all seem embarrassed by how bad and weak our currency is. Well, as with the government bond market chart shown above, I’m afraid it isn’t just us, and it isn’t our fault.
The pound is down 11.4% against the dollar over the last 12 months. The Japanese Yen is down 21.2%. The Swedish Krona is down 17.2%, the Norwegian Krone is down 13.9% and the New Zealand dollar is down 11.67%. Even the Euro which has been fairly strong this year comparatively is down 8.32%.
Overall, with regards to government debt and currencies, we haven’t had a great year, but it doesn’t really stand out when compared to the rest of ‘The Market’.
Inflation and Putin have a lot to answer for in 2022, but if it wasn’t them no doubt it would be something else.
Thursdays autumn statement will be an interesting read (if you’re into that sort of thing) but it won’t be good news for anyone, despite ‘The Markets’ reaction.
Higher taxes and spending cuts here we come.
Regardless of market direction- TPP should have you covered.
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