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March 24, 2010 10:19 pm
If Alistair Darling had tried to design a Budget to cause the minimum of market reaction, he could scarcely have done a better job. In the middle of intense anxieties over sovereign creditworthiness across the planet, and with UK government finances generating more concern than most, the chancellor said almost nothing to catch the market’s attention.
If this was his aim, then external events were running in his favour. The Budget is overshadowed by the looming general election. Uncertainty over the outcome has driven sterling lower this year, and will continue. For traders watching the UK opinion polls, there was little need to pay much attention to the point-scoring of the Budget speech.
Further, the UK and its fiscal worries were only a sideshow on Wednesday, as the latest worries over Greece helped push the euro to a new low against the dollar, even as concerns about the US budget deficit drove a sell-off in US Treasuries.
Given all of these winds blowing in his favour, the muted market reaction to his Budget on Wednesday was still more negative than Mr Darling might have hoped.
Sterling fell sharply to challenge its lows for the year. Gilt yields spiked during the speech, although by the end of the day they had risen by less than US Treasury bond yields. The FTSE 100 fell slightly.
But such muted responses must have been disappointing for Mr Darling given that the market’s implicit judgment on the UK economy and its prospects was already very negative. Further, the most obvious short-term market-moving news in the Budget should have been positive: the government’s borrowing needs for next year are somewhat lower than had been expected by the market (at £163bn, against expectations of about £186bn), thanks to spending cuts. That in turn implies that its finances will come under somewhat less pressure than had been feared.
But 10-year gilts continue to trade at a yield of 3.97 per cent. Even after the latest spasm of worry over the eurozone, this is higher than similar Italian and Spanish government bonds, which yield 3.9 and 3.82 per cent respectively. Despite the concern generated by the peripheral countries of the eurozone in recent weeks, the market thinks the risk of default in the UK is even higher.
For this dynamic, the unobtrusive reduction in growth forecasts may be more important in the longer run. The UK faces much the same problem as Greece. Austerity cuts might reduce the deficit, but only at the cost of scuppering economic growth. That in turn could push up borrowing costs.
Further, those low growth projections sit badly with the overwhelming belief in international markets that the UK has an inflation problem unlike any other. This shows up clearly from the market’s expectations for inflation: 2.95 per cent for the UK over the next 10 years, more than a percentage point higher than Germany.
Low growth and rising inflation is an awful combination, both for Britons and investors in sterling.
The scale of sterling’s devaluation since it peaked at $2.10 in 2007 has enabled Britain to muddle through the crisis rather more easily than its peers. But the cost of devaluation generally has to be paid in higher inflation. The deflationary scare that accompanied the collapse of Lehman Brothers in late 2008 kept fears of inflation in check for a while, but they are now back in full force.
The bizarre bounce in the housing market underlines the embedded inflationary psychology. Unlike virtually all the asset price bubbles of the last decade, housing failed to retreat to prices in line with long-term trends before taking off again. Mr Darling went out of his way in the Budget to inflate it a little more.
Sterling avoided greater damage on Wednesday because there were even greater worries about the other leading economies. Mr Darling successfully avoided doing anything to make the pressures worse.
But it is hard to see anything to stop the downward pressure on the currency this side of the election. The next government will have great difficulty reversing sterling’s decline.
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