UK Budget poses risks for sterling, further tax rises and heavy borrowing could

The question that matters most to us is how the budget could affect the pound and the gilt market. We see the fallout in markets as dependent on whether Healey can keep the economic damage to a minimum, while convincing markets that future spending plans won’t come at the expense of debt sustainability.

A positive case for GBP - boring is bullish:

A restoration of the buffer to around the £15-20bn level, modest spending increases within the £4-5.5bn range and a package of small, targeted tax hikes with early revenue would show Healey is serious about the fiscal rules.

Property-focused measures would be viewed as among the least damaging to growth and raise hopes that economic activity continues to prove more resilient than feared. Less long-dated issuance would likely ease pressure on 30-year gilts and provide the pound with modest upside.

This, we think, would also provide room for the Bank of England to raise rates in November, without fear of overtightening financial conditions. Another bullish signal for GBP would be the unveiling of cuts to welfare spending, though this is politically very difficult and appears to be off the table."

A negative case for GBP - half a buffer is no buffer at all:

A smaller fiscal headroom - which we would class as anything less than £15bn - would raise concern over whether it can absorb further shocks, with a fresh gilt sell off to erode the buffer before the budget is even delivered.

Bigger spending increases and back-loaded tax hikes with uncertain revenue would raise the risk of more tax hikes down the road. Even modest spending increases, particularly in low multiplier areas, could be enough to spook investors, less due to the size of the package, more the signal that it sends.

A budget that leans heavily on capital gains tax would deepen the fiscal quagmire and growth risks, while heavy borrowing could raise debt servicing costs further and drag the pound lower.