Reeves Abandons Tax Hike Push, Sending Yields Lower as Pound Wavers

LONDON, Nov 18 (Reuters) - British politics and markets are in a tense standoff as Reform UK and the Conservative Party clash over fiscal policy, with both sides vying to shape the upcoming budget and broader economic agenda. Chancellor Rachel Reeves has drawn significant attention by signaling she will not raise income taxes, a reversal that has caused ripples in financial markets and political discourse. The uncertainty has spilled into the pound and bond markets, with sterling finding temporary stability but remaining vulnerable amid political and economic headwinds.

Investors had anticipated tax hikes to address a growing fiscal shortfall, but Reeves' decision has instead fueled speculation about alternative revenue measures and spending cuts. The move sent UK government bond yields falling and dragged sterling to a recent low against the euro. Analysts suggest the market may be bracing for a potential rate cut by the Bank of England in December, though the path is far from certain.

With key economic data due this week, including inflation figures, investors are watching closely for signs that will determine the Bank of England's next move. The UK has seen falling bond yields in recent weeks, partly driven by Reeves' earlier commitment to raising taxes-a commitment now in question. This creates a feedback loop where market expectations influence fiscal policy, and vice versa according to recent analysis.

Political and Fiscal Tensions Escalate

The political stakes are high as Reform UK pushes for significant changes to immigration, trade, and public spending, all of which have drawn sharp rebuttals from the Conservative Party and Labour. Reform UK's proposal to cut benefits for EU citizens has been met with warnings of a potential trade war with Europe, while the Tories have accused Labour of using tax increases to offset what they describe as weak welfare policies. These debates are not just ideological but have direct implications for fiscal policy and investor sentiment.

Reform UK has also come under fire for local election promises made by its groups to reduce council tax, which the party claims were not officially sanctioned. Leaders like Nigel Farage have distanced themselves from such promises, emphasizing the need for fiscal discipline and cautioning against overpromising. However, these tensions have only heightened uncertainty about the party's broader economic agenda.

Market Reactions and Sector Implications

The UK budget, due on November 26, is expected to bring significant changes that will affect various sectors differently. Banking analysts anticipate a 3% increase in the banking surcharge, which could reduce earnings for major UK banks. Retailers may see limited relief from higher business rates if exemptions are extended, while the energy sector could benefit from a potential review of the Energy Profits Levy.

The construction sector, however, is in a more favorable position. According to a recent market report, the UK construction industry is forecast to grow by 1.6% in 2025, supported by increased data center investments and government spending on infrastructure projects. Despite short-term headwinds in the residential construction sector, long-term growth is expected as the government continues to invest in key sectors like energy, healthcare, and housing according to research.

Analysts Watch for Clarity

As the political and economic landscape remains fluid, analysts are closely watching for clarity on the upcoming budget and its potential impact on the economy. The UK's leading economic indicators show a generally positive trend, with 16 out of 20 indicators rising in October. However, the recent market pullback-partly driven by AI-related concerns-has underscored the fragility of investor confidence.

The Federal Reserve's policy uncertainty has further complicated the outlook, with the UK's economic data collection challenges adding to the uncertainty. While the Fed may still opt for a rate cut in December, the UK's own policy decisions will play a critical role in shaping market expectations. Analysts suggest that a softer-than-expected inflation reading could open the door to a December rate cut, reinforcing the idea that fiscal and monetary policy will remain tightly intertwined in the months ahead.