Thoughts

January 10, 2025 | 15:30

U.K.’s Reeves Needs to Rethink Her Budget

Economist

Jennifer Lee

Senior Economist and Managing Director
Economics

Jennifer has been wi... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

Jennifer has been wi... (Read more)

For some time, I figured that since the U.K. has a trade deficit with the U.S., its economy would be sheltered from all the U.S. tariff threats. We will see what happens there, but the market focussed its attention on U.K. fiscal matters and, well, it was a rough week.

Its trade balance has not been brought into the conversation—yet. But borrowing costs this week surged (10-year Gilts at the highest since 2008) and the GBP hit a one-year low of $1.22, bringing back memories of former PM Liz Truss and Chancellor Kwasi Kwarteng. In September 2022, the duo’s free-spending/inflationary budget caused the currency to plunge to a record-low $1.035 and 30-year yields to soar over 250 bps in two months to 5%, forcing the BoE to step in and buy bonds “on whatever scale is necessary”. Truss stepped down soon after. She was brought back into the conversation this week by PM Starmer, who said she “crashed the economy”, prompting Truss to send him a “cease and desist” letter.

It is ironic: the current turmoil in U.K. markets is mainly due to ongoing concern over Chancellor Reeves’ budget. Yes, it was tabled on October 30 and the protests were immediate. But there is still fallout from the business community. This week, the CEO of one of Britain’s biggest retailers, Next, warned that sales and profits would be “anemic” this year as the economy cannot absorb these “not insignificant tax rises”. He put the blame squarely on the budget: specifically, the higher payments to national insurance that employers are required to make, and at a lower earnings threshold. It wasn’t the tax hikes themselves; rather, “the speed of which it is being done”.

To offset these higher expenses, prices will need to rise. The latest BCC report showed that 55% of the 5,000 businesses surveyed plan to raise prices in the next three months, a marked increase from Q3’s 39%. “Firms of all shapes and sizes are telling us the national insurance hike is particularly damaging.” Hiring plans are also being scaled back. The latest REC/KPMG survey, which the BoE watches (especially now given the lack of trust in the ONS data), found that job placements were at their lowest in nearly 1½ years, and vacancies fell by the most in over four years.

What will calm markets? Chancellor Reeves’ #2 told the House of Commons that British bond markets “continue to function in an orderly way” and “there is no need for any emergency intervention”. Really? I don’t think there is anything “orderly” about this week’s actions. Treasury claimed that it has an “iron grip” on its finances, but the Chancellor may need to prove it by revising her budget. Meanwhile, our Laurence Mutkin, Head of EMEA Rates Strategy, mused that BoE policymaker Sarah Breeden and Governor Bailey could move to the cut camp, prompting a 5-to-4 vote to ease in February. Further out, the market is pricing just 4.20% for end-2025, implying a terminal rate of 4%-to-4.25%.

The U.K. also has another problem. President-elect Trump’s key advisor, Elon Musk, has been laser-focussed on all things Europe lately. Besides giving the AfD’s leader a very public forum to share her vision for Germany, he is also now looking at ways to push PM Starmer out, and be replaced by the Reform Party. (He had a falling out with Nigel Farage, once his BFF. He wrote on a social media post that Farage “doesn’t have what it takes” to lead the right-wing party. Ouch.) Political interference from an outsider is typically not welcome, but that is especially so now.