Britain expected to announce tax cuts this week, Bank of England interest rate cut to be blocked?

The British Chancellor of the Exchequer, Sunak, may be under pressure to announce pre-election fiscal stimulus in the spring budget this week, causing bond investors to prepare for potential inflation. Royal London Asset Management and Candriam are bracing for this scenario: proposed tax cuts could push up consumer prices, making it difficult for the Bank of England to cut interest rates significantly as expected by the market this year, and exacerbating bond sell-offs. While the market does not expect a repeat of the turmoil caused by the Trass budget debacle, investors are concerned that Sunak may use the budget to salvage the Conservative Party's political fortunes before the upcoming general election later this year. Many in his party are calling for an overall reduction in the tax burden, which has now reached the highest levels since World War II. Justin Onuekwusi, Chief Investment Officer at wealth management company St. James's Place, said: "Given the poll results, the likelihood of some fiscal stimulus before the election is quite high." The company manages 153 billion in assets and holds a neutral position on UK government bonds. Meanwhile, Royal London Asset Management is bullish on long-dated gilts, betting that the yield curve will flatten, while Candriam recently shifted its position on UK bonds from bullish to neutral. Fiscal stimulus could lead to higher inflation and dampen expectations of interest rate cuts Any fiscal stimulus measures could potentially worsen the outlook for UK bonds, which had a poor start to the year. Traders have significantly lowered their expectations for interest rate cuts due to concerns about sustained inflationary pressure and strong consumer spending. Similar repricing in the US markets of bets on Fed rate cuts also contributed to these moves. At the end of last year, money markets expected the Bank of England to cut rates up to six times by 25 basis points by 2024, with the first cut projected for May. Now, only three rate cuts have been fully priced in, and markets expect the first cut to begin in August. The two-year UK government bond yield closely tied to monetary policy expectations has risen by 60 basis points since the start of the year, the highest increase among developed countries. The benchmark 10-year UK government bond yield has shown a similar increase, exceeding 4%. Craig Inch, Head of Rates and Cash at Royal London Asset Management, stated: "If tax cuts and tax relief measures are in place to boost economic activity, then the Bank of England's Monetary Policy Committee may find it difficult to cut rates significantly this year as expected by the market." Sunak told colleagues at a private meeting on February 26 that he would seek "sensible tax cuts" in the spring budget, with the scale not being the same as in the Autumn Budget last November. The budget includes cutting job taxes and extending a plan that allows businesses to deduct investment costs from taxes permanently. In two television interviews on Sunday, Sunak attempted to temper expectations for attention-grabbing tax cuts. He said his budget would be "cautious" and "responsible," and he hoped to show a path to a low-tax economy. Sunak is restricted by his own fiscal rules, which require him to ensure that debt falls within five years. Forecasts from the Office for Budget Responsibility (OBR) suggest Sunak has around 13 billion ($16.5 billion) in headroom, the lowest level on record, leaving little room for large-scale tax cuts after setting aside some emergency buffers. This has led the UK government to consider cutting spending to fund more significant tax cuts, which itself carries political risks given the Conservative Party's decade of austerity policies. However, analysts from Resolution Foundation and Goldman Sachs estimate that the substantial fiscal surplus from the record could allow for a much higher use of the remaining headroom, reaching around 23 billion. This would enable Sunak to cancel the planned 5p fuel duty increase (2 billion) and reduce the basic income tax rate by 2 percentage points (14 billion). Analysts at Goldman Sachs, including Sven Jari Stehn, stated: "The minor changes in supply-demand balance reinforce our view that the Bank of England may wait until June to cut rates." Analysts from HSBC, including Daniela Russell, expect the UK to introduce around $12 billion in fiscal stimulus, as the government "hopes to avoid reminders of the events of Autumn 2022," which has minimal impact on inflation and "will not have a significant impact on the Bank of England's thinking." The Bank of England expects inflation to fall from the current 4% to its 2% target over the coming months, but officials warn that inflation could rise again by the end of the year due to changes in energy prices. An analysis from the Bank of England shows that the 20 billion in business and personal tax cuts proposed in Sunak's Autumn Budget will cause inflation but emphasizes a minimal impact. Philippe Noyard, Global Head of Fixed Income at Candriam, said: "The Conservative government may introduce a budget favorable to voters on the eve of the election, leading to a modest increase in inflation." This has left traders and market strategists looking for direction from Wednesday's budget. Sunak's statement on how tax cuts will be implemented, especially in light of the inflation outlook and the Bank of England's policy path, has become a key factor in how investors decide to allocate cash. Nick Rees, a forex analyst at Monex Europe in London, said the budget "should indeed help to clarify some key risks facing the market this year."