Pound rises and bond yields drop after U.K. government scraps plan to cut taxes for wealthiest earners

By Jamie Chisholm

Sterling rose and government bond yields fell after the U.K. government said it would not go ahead with scrapping the highest tax rate, cancelling one of the key components of a debt-funded budget that had roiled financial markets.

Chancellor Kwasi Kwarteng said: “It is clear that the abolition of the 45p tax rate has become a distraction from our overriding mission to tackle the challenges facing our country. As a result, I’m announcing we are not proceeding with the abolition of the 45p tax rate. We get it, and we have listened.”

The U.K. has a 45% tax rate on those earning above £150,000.

The move came as the chancellor as well as Prime Minister Liz Truss received heavy pushback from members of their own ruling Conservative party as it gathered for its annual meeting in the midlands city of Birmingham.

Ex-cabinet minister Grant Shapps said over the weekend that Truss could lose a parliamentary vote on the tax cut, which benefited richer Britons, and another former minister, Michael Gove, argued that the proposal was a mistake and should be reversed.

The response from the financial markets had been even more severe, with sterling /zigman2/quotes/210561263/realtime/sampled GBPUSD +0.1822% last week falling to a record low versus the dollar and the Bank of England forced to step in to support the bond market as investors baulked at the prospect of a tax-cutting budget funded by extra borrowing and likely to add to inflationary pressures.

News of the U-turn on Monday provided support to U.K. assets. The pound, which on Wednesday fell to $1.035, its cheapest ever, reversed an early session decline to trade up 0.3% to $1.1205.

The benchmark 10-year gilt yield /zigman2/quotes/211347177/realtime BX:TMBMKGB-10Y +0.35% fell 16 basis points to 3.988%. Benchmark yields last week surged above 4.5% for the first time since 2008 as frantic selling by pension funds facing margin calls caused panic, forcing the BoE to pledge a period of unlimited buying to underpin prices.

Mohamed El-Erian, adviser to Allianz and Gramercy, said the policy U-turn showed “there is still some life in the ‘bond vigilantes'”.

“The great Truss retreat on tax saw the pound surge briefly in value, jumping above $1.12, up by round 1% in a matter of minutes just after rumors swirled about the move, ” noted Susan Streeter, senior investment and markets analyst, Hargreaves Lansdown.

“It’s lost some of its bounce though as the financial markets digest the latest political turmoil to beset the U.K. The prime minister was hoping to carve out a reputation as the new Iron Lady, instead she will be seen as highly malleable,” she added.

Russ Mould, investment director at AJ Bell, noted that a fair chunk of sterling’s gains were given up in early trading Monday, with traders noting that dropping the high-rate tax cut would only save about £2 billion a year of a total package costing around £45bn.

“The fact that both the pound fell back and gilt rates started to move higher[from session lows] after the news had been digested is the market’s way of saying there are still plenty of problems with the Government’s finances, state of the consumer and business, and economic outlook. With or without the 45% tax cut, the country still faces challenging times with individuals and companies finding life a lot harder,” said Mould.

The turmoil in the U.K. bond markets had spread anxiety across global markets last week and so the fall in gilt yields helped the dollar inch lower /zigman2/quotes/210598269/delayed DXY +0.04% and delivered a boost to S&P 500 futures /zigman2/quotes/209948968/delayed ES00 -0.19% .