Market reaction to government U-turns shows credibility still at stake

It may seem a bit odd that financial markets reacted so sharply to images of a visibly upset Chancellor on Wednesday afternoon. The yield on 10-year government debt jumped by almost 20bps and the pound dropped by almost 1% on speculation that Rachel Reeves’s time as Chancellor was coming to an early end. Prime Minister Keir Starmer’s full-throated endorsement of the Chancellor on Thursday managed to undo much of the damage, but the episode highlights a number of challenges facing the government.

First, it’s clear that financial markets are still watching the UK like a hawk. Since the disastrous Liz Truss mini-budget, there’s been a premium on the cost of UK government debt, making it more expensive for the UK to borrow than it is for our competitors. This premium has remained despite the change in government. Clearly, the UK is still suffering from a credibility problem.

Rachel Reeves is synonymous with her fiscal rules, so sacking her would be seen by the market as potentially ditching that framework, opening up the prospect of even more borrowing, which explains the financial markets’ reaction. This should serve as a warning to those backbench MPs who advocate for reforming – or even dropping – the fiscal rules less than a year after they were announced.

Second, by U-turning on the winter fuel payments and now benefits reform, the government has set a precedent that will make it almost impossible to get any cost-saving measures through parliament. If any fiscal consolidation is needed, then it will have to come from higher taxes rather than spending cuts or higher borrowing.

Third, the U-turns on spending cuts have virtually wiped out the £10bn headroom the Chancellor clawed back in March. Admittedly, gilt yields have fallen a little since March, easing some of the pressure. But, overall, the fiscal headroom looks gone. The bigger risk is that the Office for Budget Responsibility (OBR) downgrades its economic forecasts to reflect weaker economic data and lower net migration.

Forecasting a forecast is a bit of a mug’s game, but given that a 0.1ppt reduction in the growth forecast adds about £8bn to borrowing, it’s not difficult to see OBR economic forecast changes costing around £15bn. That puts the new fiscal gap at the upper end of our £10–20bn estimate.

So, what are the Chancellor’s options given the manifesto commitments?

The most obvious is another round of duty and regulated price increases. Fuel duty may be increased for the first time since 2011, given that petrol prices are at their lowest level since the pandemic. Expect the other ‘sin’ taxes to go up as well. The risk here is that rather than inflation falling back to around 2.5% in April as the last round of duty increases drops out of the annual comparison, it stays above 3%. Not only would that dampen real-income growth, but it could also scupper any further interest rate cuts towards the end of the year.

Second, freezing income tax thresholds for another 12 months probably bags Reeves almost £10bn. This seems like a no-brainer in the circumstances.

These stealth tax rises are probably enough to get the Chancellor most of the way with a bit of fiscal fudging to make up the difference. If it turns out the fiscal hole is even bigger (some estimates have put it as high as £60bn), then pension changes seem more likely than asking businesses again.

Of course, October is still a long way off and things could move in the government’s favour, but further tax rises in the autumn look increasingly inevitable. This will prompt plenty of unhelpful (from an economic point of view at least) speculation about which taxes will rise and by how much. The bigger risk is that given ever-increasing spending pressures, continued low economic growth and no political appetite for spending cuts, every budget for the rest of this parliament takes on a similar look.

Economy likely returned to growth in May

We expect the economy grew 0.1% in May, recovering slightly from April’s big drop as activity started to normalise after tax front-running unwound in April.

The return to some growth primarily reflects a recovery in Professional Services. Here output fell by 2.4% in April overall thanks to a collapse in likely conveyancing-linked legal activities, which fell 10% as Stamp Duty threshold changes took effect. Fortunately, residential property transactions bounced back in May (+25% m/m), helping drive services output to a 0.2% m/m gain.

That said, we do think consumer-facing services will fare poorly in May. While car registrations recovered in May after Q1’s Vehicle Excise Duty front-running, we expect a 0.5% m/m drop in Retail and Wholesale activity after retail sales fell by 2.7%. Our CGA-RSM Hospitality Tracker also showed total sales growth slowing to 1.6% y/y from a bumper 6.8% in April. We therefore anticipate Accommodation and Food Services output will fall 1.6% in May, despite the sector's recent strength.

Turning to the production side of the economy, the Manufacturing Purchasing Managers’ Index (Manufacturing PMI) has been steadily recovering as tariff uncertainty fades. However, hovering at around 47, the measure still points to falling output. The sector is also yet to give back all its huge gain in February from tariff front-running. Compounding this weakness, Mining output is likely to fall by 3% as the volume of North Sea oil transferred for refining fell by 6.2% m/m after a 3.5% surge in April.

Overall, we still expect the economy to grow 0.2% in Q2. Admittedly, that looks optimistic in the face of a big contraction in April and only a small gain in May. However, all the PMIs rebounded strongly in June and good weather should lead to a bounce-back in construction and consumer-facing services. Ultimately, growth in Q2 will look weak compared to Q1 as tariff and tax front-running unwind, which will weigh on growth.