8 January 2025: Another tax raid is looking increasingly likely

The yield on the thirty-year gilt rose to 5.25% yesterday, its highest level in over twenty-five years. It also exceeded its high from October 2022, as the Office for Budget Responsibility warned that Rachel Reeves is in danger of missing her own fiscal target.

The market is becoming more concerned about debt levels in the UK and the U.S. and is, therefore, charging a greater premium for bond issuance.

The rates charged by the market bear no resemblance to the rates being paid by consumers for their borrowing, except for mortgages, which use the rate as a reference. There has been no noticeable increase in mortgage rates so far.

Higher borrowing costs are likely to make it harder for Reeves to meet her budget rules and could require her to increase taxes again, having already hit employers with higher social security contribution requirements.

The government’s budget watchdog has estimated a 1 percentage point rise in gilt yields, if permanent, would add 12 billion pounds a year to government borrowing costs over the life of this Parliament.

Rates are also rising because the market fears that the economy may be heading for a deeper downturn than had previously been predicted, possibly ending in a mild recession.

Economists and commentators fear that with the Prime Minister and Chancellor being so heavily committed to growing the economy, having placed so much political capital towards funding increased infrastructure development, including up to 1.5 million new homes by 2029, cutting NHS waiting lists and providing 6,500 new teachers to increase capacity in core subjects, that they will need to either borrow more or raise taxes again to fund their plans.

There will be no Spring Budget this year, as the Treasury will implement the changes announced by Reeves last October.

The stalling of economic output and therefore growth is the worst of all possible outcomes for the chancellor. She had gambled that growth would be “naturally” occurring, but her Autumn Statement in which she raised taxes which she had previously vowed not to, has hit business confidence to such a degree that businesses no longer feel able to commit to the investment plans that they had earlier put in place.

Reeves will attend the World Economic Forum in Davos in a couple of weeks and far from drumming up new investment for “UK PLC” she will more likely go cap in hand looking for “friendly” countries willing to do business with a country that is sliding towards recession.

The pound fell back to a low of 1.2479 yesterday as President-elect Trump partially unveiled some of his plans for the economy, including possibly making his plans for tariffs more targeted.

It closed at 1.2480 as investors grew more concerned about the country’s cost of borrowing,

On the face of it, President-Elect Donald Trump will inherit an economy that is close to booming when he takes over in less than two weeks.

However, headwinds are beginning to increase, mostly based on the level of Federal Borrowing that he is also going to inherit.

The final employment report for 2024, which will be published this week, will likely show that job creation remained steady in December. The incredibly difficult-to-predict number for non-farm payrolls is expected to be between 140k and 160k, although the predictions range between 120k and 250k.

Severe weather, which affected the data in the Autumn, may again be a factor in the headline number, although the unemployment rate should stay well below the 5% level which in the past denoted full employment.

Average earnings are expected to have risen by 0.3%, down from 0.4% monthly, contributing to an unchanged yearly rate of 4%. This is still too high for the Fed’s liking since earnings are one of the major contributors to inflation.

Data for economic output was published yesterday. Services output which was expected to have shown healthy growth exceeded expectations. The Services PMI was predicted to have grown to 54, reaching 54.2.

Services output has replaced manufacturing output as a measure of the economy since the decline in manufacturing that has taken place over the past decade.

The JOLTS job openings data, which forms part of the whole “jobs package” was also published yesterday. The data showed that the number of job openings on the last business day of November stood at 8.09 million. This reading followed the 7.83 million reported in October and came in above the market expectation of 7.7 million.

Fed Governor Christopher Waller will deliver a lecture at an event in Paris later today about the economic outlook.

Waller, who is considered a “marginal hawk” will most likely say that he expects a loosening of monetary policy throughout 2025, but rate cuts will likely be gradual.

The dollar index recovered yesterday following two sessions of mild correction. It reached a high of 108.70 where it ended the day.

Pan Eurozone headline inflation grew yearly to 2.4% in December, up from 2.2% in November. It is unclear yet if this will promote a change in the ECB’s expected programme of rate cuts, due to take place throughout this year.

The Governing Council will face a thorny task in trying to plot a path for interest rates considering inflation, which is now running well above its self-imposed target of 2% while the economy heads towards stagnation.

Christine Lagarde will be aware of the perils of stagflation, which lurks behind every set of data that the region publishes.

The conditions which lead to stagflation are almost impossible to replicate, and no major economy has yet fallen into such a state. However, with commitments to both promoting growth and taming inflation, the ECB may be close to doing so.

Core inflation, which strips out volatile items such as food and energy, remained steady at 2.7%, in line with forecasts. While the figure aligns with expectations, it underscores the persistent challenge of bringing underlying inflation closer to the ECB’s 2% target.

Among the key components of inflation, services continued to lead with an annual rate of 4%, slightly up from 3.9% in November.

Energy prices recorded a significant rebound, rising 0.1% year-on-year after falling -2% in November, reflecting higher fuel costs in some eurozone countries.

Services and the continued fluctuation of energy costs have become the most significant drivers of inflation.

Inflation varied significantly across member states. Croatia led with a 4.5% annual harmonized rate, followed by Belgium with 4.4%.

Other key readings included Germany at 2.8%, Greece at 2.9%, and Spain at 2.8%. In both Belgium and Germany, monthly inflation rose by 0.7%, the second-highest across member states.

Ireland, despite having the lowest annual inflation at 1%, saw a notable monthly spike of 0.9%.

In contrast, Italy, which recorded one of the lowest annual rates at 1.4%, registered only a 0.1% monthly rise.

France saw its annual harmonized inflation rise from 1.7% to 1.8%, the highest since August. Spain recorded an annual inflation rate of 2.8%, the highest since July 2024.

The Netherlands’ rate of inflation was 3.9%, its highest since July 2023.

The wide variance of inflation across the region contributes to two key issues for the ECB. First, the wide variety of inflation rates renders the overall target superfluous. There is no such thing as an” average” EU member, so the idea of a harmonized rate is of no use.

Furthermore, trying to create a one-size-fits-all monetary policy for the region will never work, since setting rates for a country like Croatia (annual inflation rate of 4.5%) is vastly different to setting rates for Ireland (annual inflation rate of 1%).

The euro is still under pressure from a dominant USD. Yesterday, it fell to a low of 1.0344. While there is good interest in buying at lower levels, the market is awaiting President Trump’s inauguration before formulating a path for the first quarter of 2025.

Have a great day!