UK Budget review: Relief for now but fiscal doubts remain

• The UK’s Autumn Budget delivered few meaningful surprises. Ultimately it was another higher-tax, higher-spend Budget from the government which does little to change prevailing narratives. The government’s decision to raise its headroom to GBP 22bn was welcome, but the back-loaded nature of the fiscal consolidation comes with obvious credibility risks.
• Risks around our current forecast of 1.2% growth next year now look tilted to the upside given policy support to the disinflation process and lack of any immediate tax rises. The government will hope that sentiment recovers into next year now that the fiscal fog has cleared.
• From a BoE perspective, there are no obvious areas for concern. The range of disinflationary policies next year and the tolerable increase in the minimum wage will help to reinforce the sense that inflation has peaked. All told, it seems that another hurdle has been cleared for a cut at the next meeting, but we see no reason to change our view on the terminal rate next year (3.25%).
• With no nasty surprises in today’s budget the initial market reaction has been one of relief with Gilt yields falling and the pound strengthening. That could persist for a period over the very short-term but with the budget offering no reason for any fundamental rethink of the fiscal risks ahead we see no reason to alter our FX and rates views.

Macro view: Higher tax, low credibility?

The government has a little more breathing space, for now

The early release of the OBR’s document certainly kept us on our toes but otherwise there were few surprises in the UK’s Autumn Budget, with most of the specific policy choices trailed in advance (our preview here). The OBR duly downgraded its trend productivity growth assumptions by 0.3pp to 1.0%, in line with reports, after years of overly optimistic expectations. The growth projections were downgraded accordingly with trend now seen at 1.5% (which looks much more credible than the 1.8% previously).

The effect of this downgrade on the fiscal headroom calculation was more than offset by more favourable changes elsewhere, namely on inflation and wage growth. Despite all the talk of a large fiscal shortfall, it was surprising to see that the chancellor would have actually met her fiscal rules, albeit by a slim margin of just 4bn, before policy changes were taken into account.

With that extra leeway, the chancellor chose to more than double the headroom from 9.9bn to 21.7bn (0.6% of GDP). That is more than the 15-20bn we had expected and clearly a step in the right direction. It’s worth noting that the fiscal rules are adjusted from 2026-27 (see here). While the binding year of the rolling projection horizon is brought forward to the third year, a current budget deficit of 0.5% of GDP will then be tolerated, which will increase the government’s breathing space relative to the rules.

The OBR has revised down its trend growth assumptions

Higher borrowing across the horizon

But the profile of the policy choices, in particular, will raise plenty of questions about credibility. Ultimately this was another higher-tax, higher-spend budget from the government. Income tax thresholds will be frozen for longer which, alongside a range of other measures, amounts to 26bn of tax rises in 2029-30. On the expenditure side, policy U-turns, removing the two-child benefit cap and reducing levies on household energy bills lifts spending in every year of the projection horizon. Direct policy choices on spending will reduce headroom by 4bn.

Consolidation in the form of tax rises is “back-loaded”, in the words of the OBR, and due to be implemented around the time of the next general election. There is usually an element of optimism further ahead as governments look to game the projections, and that is certainly the case with these numbers.

As well as increasing its headroom, the government will hope that tweaks to the fiscal framework will help reduce the cycle of speculation. The OBR will continue to publish a second forecast in the spring but the government hopes it will be more of an “interim update”, saying that it “will not normally respond with fiscal policy, unless there is a significant change to the economic outlook that requires a response”. Less frequent policy tinkering would be welcome, but the move won’t do much to prevent speculation around consolidation if it’s clear that outturn data is undershooting the OBR’s projections.

More broadly, the Budget process, with the constant trial balloons for policies and apparent last-minute decisions, has done little to reassure us that the government has a clear long-term strategy here. It seems strange that the government allowed so much speculation around income tax rate rises, for example, when the OBR’s projections show it was on course to meet the fiscal rules after all.

But looking ahead, the hope will be that business and consumer sentiment will improve into next year now that the fiscal fog has cleared. We expected a bigger shortfall which would have had to be addressed with more in the way of immediate tax rises. As a result the lack of any immediate consolidation poses upside risks to our current 2026 forecast (1.2%). Confidence could also be supported by lower inflation prints over coming months with a significant move lower on base effects and energy policy then likely from April next year.

The path continues to clear for more BoE easing

From a BoE perspective, we have expected the next cut in December for some time. We think that ultimately this Budget will be perceived as dovish by the BoE, and so another hurdle has been cleared on that path. The government’s decision to reduce energy levies could shave around 25bp off headline inflation and other decisions (e.g. freezing rail fares) will further support the disinflation process. That will ease concerns around sticky inflation expectations. The 4.1% increase in the minimum wage is likely to be seen as tolerable from a monetary policy perspective. Overall, the back-loaded nature of the consolidation measures means that we’re happy with our call for a terminal rate of 3.25% next year (i.e. two more cuts after the likely December move).

Markets view: Relief for markets as a key risk event passes

Gilts can perform better with fiscal fears to recede; BoE to cut

The Gilt market has scope to outperform other key sovereign fixed income markets over the short-term with the details of the budget good enough for now to push fiscal fears to the back of investors’ minds. Gilts had a very strong October with a sharp drop in yields in part on expectations of a tough budget but also in reaction to favourable inflation and wage growth data. Half of the drop in yields in October reversed in November as fears of a less credible budget grew but today should put those fears to rest and if the macro data on inflation and wages continues its recent trend, yields can likely fall further. In our view the macro backdrop of more favourable inflation and wages set this budget apart from previous budgets since the global inflation shock unfolded from 2022. The scale of drip-feeding of information also meant that practically every tax raising measure announced today was already known by the markets. The fact that the details were already in the public domain meant the leaking of the OBR post-budget forecast update before the budget had limited financial market impact.

As outlined above much of the heavy lifting in relation to tax increases comes at the back-end of the forecast period with the freezing of income tax thresholds a key source of revenue. But even many of the smaller tax increase measures are also further out and hence from a BoE policy perspective there is limited impact. BoE Chief Economist Huw Pill has also indicated that the near-term inflation reduction measures will have limited impact on policy deliberations given these are one-off price adjustments. Hence, we have not altered our view on BoE monetary policy and expect a rate cut in December to be followed by two further cuts next year, taking the policy rate to 3.25%. This budget in our view does not alter our view of the terminal rate. The OIS market is about 10bps short of pricing our view so there is scope for front-end yields to fall further. We would also believe the risk to our view is that the BoE delivers one more additional cut than we currently assume rather than one less.

For foreign exchange, the recent history of UK budgets and pricing in the options market (risk-reversals skewed to GBP downside) suggest the market was more positioned for bad news and a negative FX reaction. That has not happened and hence over the short-term there is scope for a period of outperformance as short GBP positions are liquidated. However, we doubt that will last long and see downward pressure on front-end yields ultimately resulting in GBP underperformance. Our level of GBP bearishness is perhaps not as strong as before and given the near-term fiscal risks should subside for now, better Gilt market performance at the long-end is a positive for the pound. But overall we assume the capacity for a decline in front-end yields will be more important in influencing the pound weaker than a decline in longer-term yields due easing fiscal risks. In any case, the back-loading of the fiscal consolidation will always leave investors somewhat sceptical over the prospects of fiscal consolidation. So the reality is that better Gilt market conditions, while a positive, is more about the removal of near-term risks and uncertainties rather than a fundamental rethink from investors of the fiscal health of the UK economy.

As we have already been forecasting, we see scope for GBP/USD to advance further as the US dollar weakens again while GBP underperformance will see EUR/GBP grind further higher. The budget has not altered our forecasts and we see no reason for the budget to be reason for a sustained period of GBP outperformance. We remain long EUR/GBP as expressed in our latest FX Weekly published last Friday (here).