Downside risks suddenly increasing on fiscal risk – ING

Reports of UK Chancellor Rachel Reeves scrapping plans for income tax hikes are pressuring the pound. The gilt rally was being backed by expectations that income tax increases would have delivered the necessary fiscal tightening without stoking up inflation, ultimately allowing the Bank of England to cut rates in December and beyond. So, a double positive for UK bonds: less fiscal risk plus central bank easing, ING’s FX analyst Francesco Pesole notes.

Downside risks for the pound have increased

“It’s not clear how Reeves plans to fill the £30bn fiscal hole without touching income tax. Should she target VAT increases – an inflationary measure – a hawkish BoE repricing would hit gilts. Media reports are currently suggesting a number of options being considered. One appears to be freezing the threshold for income tax brackets, which would have a similar fiscal effect as raising the rate on one bracket and could be well received by markets.”

“EUR/GBP is trading at 0.887 at the time of writing: if gilt markets open with some meaningful losses, the risk premium on GBP can rise further and bring the pair above 0.890. Ultimately, this does not look like enough of an indication that Reeves is willing to radically change her fiscal prudence commitment.”

“And we saw in the past how unwanted gilt moves can trigger some reaction by the government aimed at reassuring markets. So even if downside risks for the pound have increased, we still expect the EUR/GBP rally to be partly reversed.”