London Session: UK Budget 2013: No fatal blow for sterling

The market reaction to today’s UK Budget for 2013/14 has been fairly muted so far. The FTSE 100 might be lagging its counterparts in Europe, but at the time of writing it remained in positive territory, likewise, Gilt yields are close to their lowest level of the year and the pound is back above 1.5150. Overall, the market hasn’t been spooked by the sharp revision lower in growth, and also the increase in borrowing for this year (tucked away deep within the Budget document and side-stepped by Osborne during his speech). This Budget was less boring than most expected, here are the highlights:

· Economic forecasts

GDP for 2013: 0.6% (half the previous forecast), for 2013, growth forecast is 1.8%, down from 2% for 2014. The deficit is expected to decline to 7.4% this year, down by a third since its peak in 2009/10.

· Change to the BOE remit. This was eagerly anticipated by the market. However, the change to the remit was less radical than many expected. The CPI target will stay at 2%, although the Chancellor said the MPC needs to explain why inflation misses the target in a letter to be delivered to the Chancellor with the BOE minutes (as opposed to the release of CPI data). While this allows a little more flexibility around inflation, especially when growth is weak, it is not a game changer. The change to the remit will make the BOE more Fed-like, in that the BOE will also have to give its view as to how long it will take for inflation to fall back to the target rate. We think this paves the way for monthly press conferences from the BOE, like what the ECB and Fed already do, however, this was not announced as part of the remit change. Overall, the BOE’s remit did not have a big impact on sterling. Much more important in the ST was the boost the pound received from less QE-friendly minutes from the March BOE meeting and better than expected employment data.

· Changes to tax include:

1, Employment allowance – employers don’t have to pay the first GBP 2,000 of employees’ National Insurance

2, The rise in fuel duty has been scrapped for the next fiscal year.

3, The corporate tax rate will fall by 1% to 20% by 2015, as expected.

4, The personal allowance will be raised to GBP 10,000 in 2014 – earlier than expected.

· Highlights to public spending

1, GBP 3.5bn over the next three years to go towards shared equity loans for new build homes. It will also offer guarantees to support GBP 130 billion of mortgages.

2, Public sector pay rises frozen at 1% - this will also apply to those on a sliding pay scale.

Overall, the Chancellor’s tax giveaway was more generous than expected, which is market positive. The new scheme to help boost demand for new homes and help generate construction jobs is an interesting idea. Guaranteeing mortgages is a little concerning –will the UK end up with a problem like Fannie and Freddie? However, the fact the amount of guarantees is capped at GBP130 billion might mitigate the risks for the public balance sheet. However, the problem with this scheme is can the new build homes be built within easy access of big cities where the bulk of economic activity is taking place? London is surrounded by Green Belt land that is protected by strict building regulations. Unless these are loosened this scheme could fall flat…

The growth forecast for 2013 was cut in half, yet the market barely blinked. The BOE and the government have whittled down growth forecasts for many years, thus we would expect further downward revisions, especially if we get a contraction to GDP for Q1 and growth in the manufacturing and service sectors does not pick up.

The deficit forecast for this year at 7.4% is much higher than the 3% deficit target for the Eurozone. Although some Eurozone members have said they will miss this target, the UK’s deficit may still be one of the highest in the EU for 2013. However, we don’t think this is a negative for the UK from a market standpoint as austerity is associated with anti-growth. So a slow and steady reduction in the deficit is preferable to a short, sharp slashing of deficits that choke an already weakened economy.

Medium-term market impact:

Sterling: Mildly Bullish. Expectations for a very dovish new remit for the BOE were unfounded. Combined with signs that the BOE is uncomfortable with the decline in sterling and the rising level of inflation this suggests that we could have put in a medium-term bottom for GBPUSD at 1.4830.

UK stocks: Neutral: The change to employers’ National Insurance contributions is positive for small businesses. Overall, the FTSE 100 is a global index, thus market sentiment and the on-going Eurozone crisis are more important for the overall direction of the market. However, certain sectors will benefit from this budget, including the homebuilders and also global energy companies with fracking/ shale gas capabilities, as the Chancellor pledged a tax break if the UK can join in with the fracking craze taking over the US.

UK Gilts: Gilt yields remain close to their lowest levels of the year. They were slightly higher after the Budget; however, Osborne’s pledge to keep this Budget fiscally neutral suggests it will have a minimal impact on the Gilt market. Likewise, the downward revision to growth and the extension to the government’s fiscal targets were widely expected by the bond market. The near to medium-term direction of the Gilt market is likely to be driven by safe haven flows into UK debt if the Eurozone crisis flares up once more.

One to Watch: What now for GBP?

In recent days two things have happened that could limit GBP weakness in the medium-term: 1, the flare up of Eurozone concerns and the crisis in Cyprus, 2, the less radical than expected change to the BOE remit, and growing signs that the BOE is uncomfortable with the sharp decline in sterling.

Thus, the decline to 1.4830 in GBPUSD last week, could be a medium-term low, while 1.5220, then 1.5280 are near term resistance levels. Overall, from a fundamental perspective we think GBPUSD could stage a modest recovery from here, and from a technical perspective above 1.5125 (daily pivot) is mildly bullish for this cross.