The pound may rise further on trust in the new government
The pound has performed well so far this year but, for it to continue to do so, the financial market is going to have to put a lot of trust in the new government.
The quarterly Confederation of British Industry (CBI) survey of business confidence for October took a significant downturn. It showed that a net 24% of firms are pessimistic about the business outlook—a sharp jump from the 9% the period before. That’s quite a swing and seems due to the fact that the new Labour government has warned that next week’s budget will be tough. It is what we would call a ‘jam tomorrow’ budget, meaning that the government is telling people that they may have to undergo some pain now but there will be benefits (the jam) in the future, presumably at the time the Labour government has to fight the next election!
So, there is a significant amount of trust needed here. Firms and consumers have to trust that a tough budget is needed now and that better times will come in the future. There is clearly a risk here that the government destroys all the positive sentiment that seemed to be around when it took power in July. Indeed, we’ve already mentioned how business sentiment seems to have fallen within the CBI survey and other measures of activity, like yesterday’s PMI survey, were also soft as well. But will such a doom loop develop?
The Standard Bank doubts it. One reason is that the government has warned that the budget will be very tough, but another trick that politicians often use is to gird people for a very negative outcome and then produce something that is not as bad as feared. And this is what we’d expect to happen in this case. As a result, it is sceptical that the budget will weigh heavily on economic activity and, besides, there is still the prospect of more Bank of England rate cuts to sooth the fiscal pain.
This being said, there’s a second set of actors that need to show trust in the Labour government. These actors are in the financial markets and, if they get upset with the government, it could stymie the chances of the Bank of England cutting rates in the way that is priced into the market right now. The need for trust arises because the government will be gerrymandering its definition of public debt in order to free more fiscal headroom to invest.
Chancellor Reeves said that the government will be switching to a new definition of debt, and, surprise, surprise, it is likely to be one that gives significant new licence for the government to spend more on investment. The speculation is that the current Public Sector Net Debt, excluding BoE support (PSND ex BoE), will be replaced by a definition termed Public Sector Net Financial Liabilities (PSNFL). This new definition includes illiquid financial assets such as student loans and is said by some to give Reeves as much as GBP50bn in new spending ability.
Now that can’t be used to cut taxes or raise day-to-day spending, but it can, it seems, be used in part or fully to raise investment. The key question is whether the market will trust the new government on this one. Will it see the change in the debt definition as a controversial way of funding injudicious fiscal largesse or a benign change in the debt classification that frees up room for much-needed public investment?
Given the backdrop of the September 2022 mini-budget government, when the former Conservative government managed to blow up the pound and the gilt market, it might seem that the new Labour government is playing with fire here. But the Standard Bank does not think so.
“We think that the market will trust these definitional changes and the major thrust of the budget. And we also think that the wider public will trust the government to deliver jam tomorrow once the budget pain of this year’s fiscal announcement is out of the way. In short, sterling has partied for much of this year, and we doubt that Labour’s first budget is going to spoil the budget. Our longer-term sights are set on 1.40-plus for the sterling dollar and 0.80 for euro/sterling and we suspect that they will still be the targets once the October 30th budget announcement has been digested,” said the Standard Bank.