What is the impact of 45p tax U-turn on markets and mortgages?

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The Guardian

Kwasi Kwarteng and Liz Truss have expended a lot of political capital by abandoning their policy to abolish the 45% top rate of income tax and after a week of increasing hostility from MPs and economists. But how has Monday morning’s humiliating U-turn gone down with markets, and has it reversed some of the mini-budget’s turbulent impact on home loans, government debt and the pound?

What does it mean for mortgages?

Last week’s “carnage” in the home loans market resulted in 40% of all products being pulled from sale by Thursday amid predictions that the Bank of England could be forced to raise the base interest rate to 6% next summer. After the U-turn that forecast fell slightly – to about 5.5%.

In theory, that should translate into slightly cheaper deals. However, Riz Malik, a director of broker R3 Mortgages, said: “Even if the markets respond well, I fear mortgage lenders may take some time to reflect positive news in their pricing.”

David Hollingworth, of the brokers L&C Mortgages, said it would “take a little time for us to be able to tell how it’s going to help”, adding that in the very short term, borrowers “have got to expect some [continued] volatility” that could mean rates on some new deals continuing to go up.

That partly reflects the fact, he added, that last week was so “helter-skelter” that some of the lenders that pulled their deals amid the chaos on the markets “have not even come back yet”. Those that have been put back on sale so far, are far more expensive.

Thousands of mortgage deals were pulled last week amid predictions that the Bank of England could be forced to raise the base interest rate to 6% next summer. Photograph: Andrew Matthews/PA

For example, NatWest announced on Sunday that it was hiking its rates from Monday. As a result, a new two-year fixed rate aimed at those looking to remortgage has leapt from 4.28% to 5.62%.

Right now, in terms of two-year fixes, 5.5%-plus “feels like where rates are sitting, [though] you can do a bit better,” said Hollingworth.

With conditions so volatile, lenders also have to assess how much business they want to take on: if they launch a rate much below that of rivals, they might risk being overwhelmed by the demand. “That thing about capacity and service and volume is a big thing for lenders,” Hollingworth said, suggesting why banks and building societies may opt not to make snap decisions.

How did markets react?

The pound rallied early on Monday after the policy reversal, initially returning to the level seen before the mini-budget with a gain of almost 2 cents against the dollar to trade close to $1.13.

UK government bond yields, which dictate the interest paid on state debt, also fell a little. Soaring yields partly precipitated the crisis on Wednesday when the Bank of England stepped in to promise to set aside £65bn to buy bonds to ease the pressure on pension funds and insurers. The Bank is continuing with its purchases until 14 October.

Analysts said the rally reflected investor relief at the government’s newfound willingness to change course. However, markets relinquished some of the earlier gains amid suggestions that Truss could be forced to make further concessions. Sterling fell back close to $1.12 by noon on Monday, while traders said the blow to the prime minister’s authority meant renewed bouts of volatility in the currency were inevitable.

Economists remain concerned about the impact of the rest of Kwasi Kwarteng’s plans. Photograph: Aaron Chown/PA

What about the public finances?

While Kwarteng’s surprise move to scrap the 45p rate was symbolic of his carefree approach – cited as a key factor behind last week’s market turmoil – it was worth just £2bn out of the £45bn in unfunded tax pledges he unveiled. Economists remain concerned about the impact of the rest of the plans.

“What was a £45bn tax-cutting package is now a £43bn package. This U-turn has, in itself, essentially no effect on fiscal sustainability,” said Paul Johnson, the director of the Institute for Fiscal Studies.

Analysts said Kwarteng could be forced to backtrack further on his promises or commit to large cuts in public spending to repair the UK’s battered credibility with global investors. Either would prove difficult, with tax cuts central to Truss’s leadership campaign, while large cuts to public services likely to be seen as electorally toxic in a cost of living crisis coming after a decade of austerity.

Walid Koudmani, the chief market analyst at the trading platform XTB, said the 45p U-turn had bought Kwarteng some time, but risks remained: “Until investors get clarity in the scale of borrowing needed and costs, which means a detailed OBR forecast [from the independent fiscal watchdog], the pound sterling volatility will likely continue.”

Is a recession still on the cards?

Keeping most of the government’s tax and spending plans intact could help reduce the likelihood of recession, but also risks stoking inflation – hence the expectation from economists that the Bank of England will still have to raise rates to pre-financial crisis levels by next summer to try to dampen soaring prices.

Neil Birrell, the chief investment officer at Premier Miton Investors, said: “The Bank of England and the government are at loggerheads and, as importantly, there is no conviction in government policy. It all makes a for a very uncertain backdrop for markets, particularly gilts and sterling.”

October 3, 2022 at 06:54PM Rupert Jones and Richard Partington

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