The Great British Turnaround | Seeking Alpha

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By Maximilian Korell

After a few tumultuous weeks, British policymakers have unwound almost all the planned growth policies. Will this be enough for gilts to rally further?

One month is a long time in politics. Prime Minister Liz Truss took office in September. Along with then-Chancellor of the Exchequer Kwasi Kwarteng, she was determined to grow the economy and avoid an all-but-inevitable recession.

The core pillars of her plan were well known, including an energy price cap to protect the consumer (about 8% of GDP) and the reversal of planned tax hikes (1.5% of GDP). However, with inflation running at 10%-plus and rising pressure on global yields, additional, unfunded tax cuts were seen as problematic. As Joe Amato, our President and CIO for Equities, argues in his latest CIO Weekly Perspectives, fiscal prudence in the current inflationary environment is of upmost importance for the U.K., which is running twin deficits; and needs fiscal credibility in order to attract foreign capital. After the new tax cuts (0.5% of GDP) were proposed, gilts and the pound took a big step lower, with markets demanding a premium to buy U.K. assets.

Fast forward to today and the package has been all but reversed. What markets are left with is a reduced support scheme for energy prices, which will end in April rather than in two years, and a cut in the stamp duty for homebuyers (1% of GDP). Despite these developments, gilt yields are higher by roughly 200 basis points and sterling is 6% cheaper relative to the U.S. dollar since mid-August when a Truss electoral win seemed increasingly likely.

Will this be enough to balance the books? The next key event for markets will be on October 31, when the new chancellor, Jeremy Hunt, is scheduled to present the Medium-Term Fiscal Plan. On Monday, he emphasized that planned spending measures would not increase the debt burden – thus suggesting to us that more spending cuts could be announced on the 31st, just three days before the next Bank of England meeting. As for the BoE, markets currently expect a 1% hike to fight domestic inflation and a terminal rate of some 5.3% in June 2023.

That said, we don’t believe the BoE will reach the market’s implied terminal yield just yet and will likely settle for a 75-basis-point hike in November to protect the local housing market. This could cause investors to demand a higher yield on longer-dated assets for as long as the domestic inflationary picture doesn’t change. Hence, we anticipate that 10-year gilt yields could reach 4.25% to 4.5% in the months ahead, albeit with lower volatility.

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