Fiscal Fold? Truss May Blink On Taxes After Market Crash

Earlier this week, I wondered if the Bank of England might be attempting to enlist markets in an effort to compel a fiscal U-turn from Liz Truss.

Andrew Bailey’s stern warning that the BoE’s emergency support for UK bonds would end as scheduled on Friday despite the very real risk of ongoing turmoil and additional forced selling from pension funds, suggested Bailey either didn’t appreciate the scope of the peril, or else had something else in mind.

“Bailey’s comments were, in my eyes, gamesmanship from the BoE back to the Truss government — a high-risk game of chicken,” one popular strategist said Wednesday. Bailey, some speculated, was conveying this message to Truss: “I’ll let markets dictate to you whether you and your budget survive.”

Fast forward a day, and sources said Truss was indeed “preparing to abandon a central part of [the government’s] tax-cutting agenda following weeks of chaos in financial markets.”

The quote is from Bloomberg’s reporting, which followed a tweet from the Sun’s Harry Cole, who said that although “no final decision has been made… there’s definitely movement.” Cole is the Sun’s political editor.

Allegedly, Truss may go ahead with a corporate tax hike next year, despite proudly scrapping it in the mini-budget (figure below).

Kwasi Kwarteng neither confirmed nor denied the reports. “Our position hasn’t changed. I will come up with the medium-term fiscal plan on October 31 and there will be more detail then,” he told the BBC, while in Washington for the IMF meetings.

Pressed on a possible reversal of the government’s corporate tax plan, Kwarteng said, “My total focus is on delivering on the mini-budget and making sure that we get growth back into our economy.” That’s not nearly emphatic enough to dispel market rumors. Not when the rumors are based on sources stories.

The pound rallied and UK yields tumbled. At one point, 30-year yields were nearly 50bps lower on Thursday, a monumental move rivaled only by that seen when the BoE announced temporary bond-buying late last month.

The two shaded circles in the figure (above) show September 28 (when the BoE intervened) and Thursday (when news of a possible Truss “fiscal fold” hit the market).

Recall that on Wednesday, long-dated gilt yields rose near levels that prompted the BoE’s emergency intervention, meaning absent a relent from Truss, gilts could exit the backstop window in no better shape than when Bailey stepped in following the extreme volatility triggered by Kwarteng’s budget unveil.

Thursday’s rumor-driven rally came after the BoE bought the most bonds yet on Wednesday, helping gilts close off their worst levels. As of this writing, long-dated yields were still around 55bps off Wednesday’s highs (figure below).

Truss was under immense pressure to fold to markets. Some Tories had demanded a U-turn. Her position, and particularly that of Kwarteng, had become wholly untenable.

The gilt rally rippled across markets Thursday, a day when risk assets were poised to suffer following another hot US CPI report. The price action was indicative of the extent to which the turmoil in UK rates had come to dominate the market narrative and thus risk sentiment.

If the BoE was in fact playing a game of chicken by pretending that no additional support for the bond market (beyond a transitional repo facility) was forthcoming after Friday, Truss might’ve swerved.