File image of Chancellor Reeves. Picture by Kirsty O'Connor / Treasury.
A tax rise won't be welcomed by workers, but for the pound, it's a relief.
Newspapers report Chancellor Rachel Reeves is considering a 2p rise in income tax to stem the UK's growing budget deficit.
The whopping tax increase will allow the UK's titanic state sector to lurch onwards; its bulky, inefficient, outdated and extremely costly frame will sail into another year without catastrophe.
A day of reckoning is coming, but for a nervous pound, that day has receded into the distance.
News of a 2p income tax rise follows Prime Minister Sir Keir Starmer's refusal on Wednesday to repeat a commitment to Labour's election manifesto that it would not increase income tax, National Insurance or VAT.
Politically, this will be a bad move for the government, but the reality it had no choice as it refuses to cut welfare spending, meaning it needs to keep lenders in the bond markets on side.
For a government that won't consider trimming the welfare budget, a big tax increase was always going to be the only credible option to pursue if it wanted to keep markets on side.
Financial analysts say the move can shore up confidence in UK financial assets such as pound sterling.
"The pressure valve release of the event risk could see a strong GBP rally," says Bank of America analyst Kamal Sharma.
The Labour Party boxed itself into a corner with a manifesto pledge not to raise the government's biggest earners.
Fears the whole fiscal framework would unravel in Liz Truss-style fashion were a significant headwind to sterling, with GBP/EUR this week falling to a new two-year low.
Having made a manifesto promise not to raise income tax, VAT or corporation tax, an income tax rise makes for a bitter political choice for Starmer and Reeves.
But for financial markets, it is a relief, as it signals the government will be able to source the funds to continue paying its lenders.
This will take pressure off bonds and means a repeat of the Liz Truss financial meltdown won't be repeated.
Above: The government relies heavily on foreign lenders. This leaves the pound at risk if foreigners lose confidence in the UK's finances.
However, it's not just fears of another Truss-style reaction weighing on the pound: the market has raised expectations for further Bank of England interest rate cuts during the course of the past week.
This repricing is a traditional headwind for the currency, and we are not surprised to see the pound adjust lower in anticipation of further rate cuts.
Why would a tax increase allow the Bank of England to cut interest rates?
The Bank of England is concerned that the economy is shedding jobs and believes it can help by lowering rates. However, still-high inflation prevents it from doing so.
Further rate cuts at the Bank become more likely because if the government raises taxes to the tune of £30BN it will constrict the economy and weigh on inflation. The government can offer more assistance on inflation if it shows restraint in raising public sector wages.
If the Bank thinks the budget will help bring inflation down, it will act to support businesses and households by lowering interest rates.
It could even cut interest rates as soon as November if is privately briefed by government that the budget will be contractionary.
Pound Rebound into December?
For the pound, there are still near-term downside risks as this repricing could run further, but even this trade is starting to look a bit dated.
"Currently the market is pricing in around a 25% probability of a BoE rate cut as early as next week, 6 November. We would view such expectations as excessive. A moderation in November BoE pricing should help limit immediate GBP downside," says Jeremy Stretch, a strategist at CIBC Capital Markets.
Beyond interest rate nuances, the bigger picture is starting to look a lot better as budget uncertainty fades: a rebound into year-end is a strong possibility.
"Historically, sterling tends to weaken heading into the Budget but sees relief thereafter," says Kiran Kowshik, Global FX Strategist at Lombard Odier. "Combined with renewed weakness in the USD, GBPUSD could see a more significant move higher heading into December if the UK budget does not surprise market expectations.