Expectations for a fresh boost to the pound

Policymakers are greatly helped if financial markets show understanding when policy changes; especially if it changes in an unexpected way. For instance, the market showed understanding when the Fed cut rates a larger-than-generally-expected 50-bps last week. Will markets be as understanding if new UK Chancellor Rachael Reeves Gerrymanders the fiscal rules to give her more room to pump up investment in next month’s budget? If this will be done, positively impacting the pound.

The manager of the Fed’s System Open Market Account (SOMA), Roberto Perli spoke earlier in the week about the fact that the Fed’s market intelligence gathering before the recent FOMC meeting had suggested the market would “understand” a large 50-bps rate cut. In other words, traders and investors would not be freaked out by the size of the cut into thinking that the Fed feared imminent economic disaster.

The fact that stocks rallied and Treasury yields rose after the 50-bps announcement supports the idea that the market understood the large cut as a sort of catch-up in the policy normalisation process and not a sign of impending economic doom. But financial markets don’t always show understanding, and responses can be very adverse as a result. One example of this was the dramatic slump in gilt prices and the pound when the former UK Conservative Prime Minister Liz Truss went AWOL with fiscal responsibility back in September 2022.

This issue is mentioned because the new Labour government also seems set to test market patience with fiscal tweaks of its own that, to some, might also appear quite irresponsible. Now, don’t get us wrong. We are not talking Lis Truss irresponsible, but something far tamer. Nonetheless, the September 2022 debacle is still fresh in the memory, and it is not beyond the realms of possibility that the bond vigilantes could take an inch and run a mile if the new government even as much as tweaks the edges of its own fiscal rules.

Speculation of a change in the fiscal rules is happening because it is believed that the Labour government wants to free up more cash for public investment. That clearly marks it out from the Truss government, whose dissing of the fiscal rules was used primarily to generate tax cuts for higher earners in the belief that trickle-down economics had never been discredited.

Besides, the Truss debacle occurred because the government ignored the independent budget adjudicator, the Office for Budget Responsibility (OBR). Labour is not looking to do this, as the tweak being considered seems to be to give the chancellor more wiggle room when it comes to the fiscal rule that states the OBR must be forecasting a decline in the net debt/GDP ratio in the fifth year of its forecast.

In other words, the government can’t do anything if it is ruled inappropriate according to the OBR’s forecasts. But how can we be so sure that tweaks to the fiscal rule that free up to as much as GBP30bn in cash to invest won’t test the markets understanding? One reason the Standard Bank thinks this is due to the fact that there appears a large amount of support from academics and significant institutions, such as the OECD, for the fiscal rules to be softened in order to try to reverse the UK’s desperately poor investment record.

In short, it seems that the government is actually responding to pressure for this change rather than leading the change, and it hints that financial markets will understand any such tweak. That is important because it may just mean that the response to the October 30^th budget is a positive one, at least for the pound, as opposed to the negative one that we might have feared a short while ago when the Chancellor stressed the limit ed room for fiscal action.

“It is worth noting that, while Labour was criticised in the run-up to the election for being too ‘safe’ in its policy prescriptions, it is becoming clearer all the time that the new government is looking to take the country in a very different direction to the prior government, notwithstanding the fact that keeping fiscal rules limit s its room for manoeuvre. If the market thinks this is a better direction, as we suspect, sterling should keep strengthening,” said the Standard Bank.