The UK’s fiscal backdrop has not materially improved in recent months, yet the market’s perception of fiscal risk has diminished considerably, teeing up a potentially dangerous setup for the Budget on 28th October.
In terms of the backdrop itself, while the overall national debt level hasn’t yet quite breached the psychologically key £3tln mark, it continues to hover just below said level. Still, even if we’ve not yet printed a three-handle, borrowing metrics remain worrying, with the deficit running around 19% higher YoY as of end-August, and around £3.5bln above the OBR’s expectations.
This single-month data feeds into what remains a worrying broader backdrop. For the financial year to date (April - August), borrowing is running around £8bln above the OBR’s projected path, while the deficit is around £5bln larger than had been projected. Added to which, the approx £23bln fiscal headroom with which the fiscal rules were being met as of March has diminished significantly, as a result of higher Gilt yields, higher Bank Rate expectations, and various spending commitments, from capping bus fares, to needing to fund the Defence Investment Plan (DIP).
What is, perhaps, even more worrying than all this, is that borrowing has continued to increase substantially, despite tax receipts having also increased notably YoY. Put simply, spending growth is outpacing the growth in receipts - a clearly unsustainable situation.
All told, then, at the Budget, Chancellor Healey will likely need to find around £15bln in order to plug yet another fiscal ‘black hole’. While, in an ideal world, said hole would be plugged through spending cuts, Labour MPs have already shown their reluctance to passing said measures in Parliament. As a result, another tax-raising Budget is on the cards, though with changes to income tax, national insurance, VAT, and corporation tax all having been ruled out, it’s difficult to see how a ‘smorgasbord’ approach of several smaller tax tweaks can be stitched together to form a credible fiscal consolidation plan.
Perhaps more worryingly, there is increasing speculation that Chancellor Healey may seek a lower level of fiscal headroom than the £23bln achieved this time last year. While the headroom number should not become a fixed target, as that would rather defeat the point of the fiscal rules, cutting the buffer even tighter than it is at present risks taking the economy down a rather dangerous road. The last six months have shown how one significant shock can, for all intents and purposes, wipe out any cushion that the Treasury had left themselves. Leaving an even smaller buffer, in a world where negative supply shocks are becoming increasingly common, and where the geopolitical backdrop remains febrile, would be a significant, and to my mind unwise, gamble to take.
Amid all this, though, the market has slowly but surely priced a lower and lower UK fiscal risk premium. We can judge this premium easily through the 10-year Gilt-Treasury spread, which has narrowed drastically from around 45bp at the end of August, to around 9bp in early-October. In fact, this spread, which some have perhaps uncharitably termed a ‘moron premium’, now sits at its tightest since last June.
This means that conditions are ripe for a ‘perfect storm’ to form - the UK’s fiscal backdrop has continued to deteriorate, the Chancellor may further narrow the buffer against future shocks, a piecemeal approach to tax hikes is unlikely to raise the revenue that the OBR pencil in, and, most importantly, markets approach the Budget pricing the UK backdrop as no riskier than that of the US, or other G7 peers, which is clearly not the case.
Given this underpriced fiscal risk, short GBP positions remain attractive, particularly if cable is able to make a sustained break beneath the $1.32 handle, which would likely open the door to a test of $1.30 in fairly short order. Staying short the long-end of the Gilt curve also remains favourable, not only amid broader headwinds to Govvies from the energy/inflation backdrop, but also as this is where a return of fiscal fears is most likely to manifest.
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