Reeves must raise taxes and cut spending, markets say

UK Finance Minister Rachel Reeves is walking a tightrope as her critical autumn budget looms, while pressure mounts to appease voters, shore up public finances and convince money markets that her policies are sensible.

Thanks to her self-imposed fiscal rules, which she has doubled down on in recent weeks, Reeves has been forced to scramble to find strategies that can plug a multibillion-pound hole in the public finances by the time she delivers the budget on November 26.

That means slashing spending or breaking a stated promise not to raise certain taxes, or a combination of both.

CNBC takes a look at some of the options on the table.

The Finance Minister has been considering a number of ways to shore up public finances, according to recent local media reports, including taxing dividends, cutting tax breaks for salary sacrifice schemes and imposing higher taxes on certain professions.

Any move to raise taxes would be unpopular.

A YouGov poll of more than 6,500 Britons in September found that almost one in three adults believe Reeves should avoid raising taxes in the budget, even if it means cutting spending or borrowing more. A separate YouGov poll found that more than half of 3,980 British adults believe Reeves should prioritize delivering on the government’s promises not to raise taxes over promises not to increase borrowing.

However, some within the money markets would welcome the tax increases. On Friday, government bonds sold off as investors reacted to reports that Reeves would do a U-turn on income tax increases that had been planned as part of the budget.

“How can this statement simultaneously promote growth while having to cut spending and increase tax burdens to keep bond investors happy?” Toni Meadows, chief investment officer at BRI Wealth Management, told CNBC at the time.

Brian Mangwiro, managing director of global sovereign debt and currencies at Barings, told CNBC that his team expects Reeves to announce some form of tax increase in the budget later this month, a move he said will be positive for UK government bonds, also known as gilts.

Barings is taking a constructive stance on gilts amid a soft labor market, weakening wage growth, hopes that inflation is peaking and the assumption that the Bank of England will continue to cut interest rates until 2026.

“A fiscally responsible budget will be an additional tailwind,” Mangwiro said by email. While arguing that the UK’s tax burden is likely to hit new records, Mangwiro said he expected financial markets to benefit from new or increased tariffs.

“We expect additional revenue to be channeled into investments given the government’s pro-growth agenda,” he said. “This will hopefully increase UK productivity in the medium term.”

Stuart Edwards, who manages the Invesco Tactical Bond Fund, also believes Reeves will deliver a “market-friendly” budget on November 26.

“In the UK, the chips are lining up for a more bond-friendly environment,” Edwards said at a recent fixed income roundtable. Edwards said the UK government and tax authorities now “recognise the situation” and have to “act sensibly” with the public finances.

“They don’t have the bandwidth to play fast and loose,” Edwards said.

The UK bond market has been rocked by episodic bouts of volatility and uncertainty since former Prime Minister Liz Truss’ mini-Budget in September 2022. “The bond market has been volatile,” Edwards said. “But there has been value in gilts, there is a big risk premium built into gilts.”

Many bond investors who spoke to CNBC said they wanted Reeves to combine tax increases with spending cuts to help control the growing government deficit.

“Gold markets need to see genuine fiscal consolidation, done in a way that is not destructive to growth. This is a difficult balance,” said Emma Moriarty, portfolio manager at CG Asset Management in London.

Part of this, he said, would have to come through broad tax increases that take immediate effect, but Moriarty said it was crucial that these were combined with “significant cuts” to spending.

The Autumn Budget comes as Reeves seeks to plug a fiscal black hole estimated to be £50 billion ($65.6 billion).

Cutting spending too drastically would likely not win much support from the ruling Labor Party’s most left-wing lawmakers, whose rebellion against an earlier attempt by Reeves to slash the country’s welfare bill led to his reforms being watered down over the summer.

“Closing a black hole of the current size entirely through taxation has the potential to weigh on economic growth for some time, not just through the direct impact on disposable income, but through more subtle behavioral impacts on the household savings rate and level of private investment, both of which have already been issues in the UK for some time,” Moriarty said.

“There is already a lot of good news priced into bond markets,” he added, noting that bond yields had fallen sharply across the curve over the past month.

“Most of this is due to positive sentiment in the US bond markets, but some is due to a higher market expectation that [Reeves] will take significant steps to improve public finances. “Therefore, there is enormous potential for these high expectations to be disappointed.”

Despite this, Barings’ Mangwiro said markets were likely to be disappointed on this front. “Given the political sensitivity, we do not expect the Chancellor to announce significant spending cuts,” he said.

Another option available to Reeves is to break his own fiscal rules, under which day-to-day public spending must be financed by tax revenue rather than borrowing, and public debt must be falling as a proportion of economic output by 2029-30.

That seems unlikely, however, after he used a surprise pre-budget speech last week to reiterate that his commitment to those rules is “firm.”

Deviating from the terms set by his own rules would also likely rattle the influential bond market, which has responded negatively to suggestions that Reeves’ pledge to bring Britain’s finances under control could be in jeopardy.

Earlier this year, doubts over Reeves’ future within the government sent bond yields soaring, while yields also rose on Tuesday amid rumors that Prime Minister Keir Starmer’s leadership was under threat.

Maxime Darmet, senior economist at Allianz Trade, told CNBC that any deviation from Reeves’ fiscal rules could rattle the bond market.

“Bond yields could be forced to rise if… the chancellor unexpectedly decides to reduce his fiscal headroom against fiscal rules, while he had previously called for an increase [or she changes] fiscal rules, which could be perceived as a waning commitment to fiscal discipline,” Darmet said.

Yields could rise if a negative political reaction to the budget leads lawmakers within his own party to demand Reeves resign, Darmet said.

Bond yields and prices move in opposite directions, so when investors are reluctant to lend to a government, the bond price falls and the yield rises.

The UK government currently has the highest borrowing costs of any G-7 nation, with its 30-year bond yield trading well above the critical 5% threshold and spending much of this year at multi-decade highs.

Dramatic increases in bond yields (essentially the amount of interest the government pays on its debt) could also have a broader impact on the broader economy.

While bond yields reflect borrowing costs for the governments that issue them, they can also affect mortgage rates, investment returns, the broader economy, and personal loans.