Pound and gilts gain after Truss changes course on 45p tax rate cut

The pound and UK government debt gained on Monday as investors gave a cautious welcome to Prime Minister Liz Truss’s U-turn on plans to scrap the top rate of income tax, just a day after insisting the controversial measure would go ahead.

Sterling rose 0.5 per cent against the dollar to $1.121, close to the level where it traded 10 days ago, before chancellor Kwasi Kwarteng announced a £45bn package of tax cuts that included the end of the 45p rate for the highest earners. Gilts also clawed back part of their recent slump, with 10-year yields falling 0.03 percentage points to 4.05 per cent, still well above the level of 3.5 per cent before the “mini” Budget.

Investors and analysts said the government’s willingness to change course was encouraging after the original plans sparked a violent gilt sell-off. That selling, in turn, threatened to trigger a liquidity crisis in the UK pensions sector until the Bank of England stepped in with two weeks of emergency bond purchases.

But investors also stressed that the amount saved by keeping the top tax rate — estimated at £2bn to £3bn a year — was small in the context of the overall fiscal package, adding that Truss’s government has a long way to go to regain the faith of markets.

“This is the babiest of baby steps to regaining fiscal credibility,” said Jordan Rochester, a foreign exchange strategist at Nomura. “It’s symbolic. The top rate of tax got the most attention but actually cost the least. It doesn’t make any sense that this would suddenly fix the Conservative party’s lurch into totally untethered fiscal easing.”

Rochester said sterling’s recovery to pre-“mini” Budget levels would be a good opportunity to renew negative bets against the currency. “Sterling doesn’t rally in a global growth slowdown,” he said.

A £2bn reduction would bring gilt issuance for the rest of this year roughly in line with market expectations prior to Kwarteng’s announcements on September 23, according to James Athey, a portfolio manager at Abrdn. The Debt Management Office increased its planned debt sales by the end of March by £70bn.

“On the face of it, just looking at the numbers, we are right back where we thought we were going to be,” Athey said. “But it was never just about the numbers. You had a whole load of other tax cuts, the refusal to engage with the Office for Budget Responsibility.”

Athey said he has reduced his short bet against gilts since the BoE’s intervention in markets, but remains positioned for higher yields. “The fragilities haven’t gone away; nothing has fundamentally changed,” he said.

Some analysts worry that the volte-face on income tax could help to entrench the rest of Kwarteng’s tax-cutting plans, which markets continue to view as a threat to the sustainability of UK public finances.

“The decision to abolish the rate cut was the least expensive and potentially the most politically popular among Tory MPs currently,” said Vasileios Gkionakis, Emea head of foreign exchange strategy at Citigroup. “In a way, it could solidify the chancellor’s position and allow him to proceed with even higher conviction with the rest of his fiscal plan.”

That plan is likely to lead to a weaker pound as international investors become increasingly reluctant to finance the UK’s current account deficit, according to Gkionakis. “We would recommend selling here,” he said.

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