UK's Rachel Reeves nears moment of truth with tax-heavy budget

By Andy Bruce

MANCHESTER, England (Reuters) -"We won't have to do a budget like this ever again," Britain's finance minister Rachel Reeves declared a year ago, insisting she had restored stability to the public finances on her first attempt and would not be coming back for more tax rises.

When Reeves presents her second annual budget on Wednesday, she is expected to announce another round of hefty tax increases, testing the confidence of the governing Labour Party and drawing scrutiny from an uneasy bond market.

It has been a difficult first 18 months in charge of the world's sixth-biggest economy for Reeves.

The former Bank of England economist - the first female chancellor of the exchequer - has staked her political identity on being the antidote to the chaos that roiled British politics in recent years.

But weeks of mixed messages from her and Prime Minister Keir Starmer on tax have strained the trust of investors and voters, leaving her credibility - and potentially Starmer's political survival - in the balance.

Only 9% of Britons think Reeves is doing a good job against 61% who do not, according to YouGov.

Critics try to mock her as "Rachel from accounts" - invoking a female office worker stereotype - but Reeves says she is not in politics to be popular and cites new public investment in nuclear power and the health service as proof of her influence.

"Have we done everything we want to do? Absolutely not, and I'm the first to recognise that," she told the BBC this month. "But we are making progress."

CHESS PLAYER HOPES TO TURN THE TABLES

A star chess player as a schoolgirl, Reeves hopes to pull off what players call a "swindle": escaping from a losing position with the guile to force a draw or win.

That means convincing financial markets that she has a credible plan for the public finances.

She must also persuade restive Labour Party colleagues that she has not squandered last year's sweeping victory and can still deliver better public services, investment and growth.

Reeves has championed "securonomics," or the need for governments to prepare for an era of constant shocks. But this month she blamed U.S. President Donald Trump's trade tariffs and global conflicts for eating up the small fiscal buffer she set herself.

A Labour lawmaker, speaking on condition of anonymity, conceded Reeves was a victim of circumstance "but maybe she should have been better prepared." 

WHAT LIES BEHIND THE "IRON-CLAD" FACADE    

Colleagues say Reeves is warmer than her public persona as the defender of her "iron-clad" fiscal rules.

That image slipped in July when she wept in parliament, prompting speculation about her future. 

"Most people have had a day at work when they go into the toilets and have a cry, or say to their boss, 'I'm just going home early.' Unfortunately, my difficult moment was on live television," she told The Times newspaper.

The episode symbolised the communications failures in Starmer's government: Starmer made clear his unqualified backing for Reeves only after a bond selloff.

With memories still fresh of the 2022 "mini‑budget" crisis under former Conservative Prime Minister Liz Truss, investors asked whether Labour grasped the risk of a loss of confidence.

INVESTORS CRITICISE REEVES, BUT FEAR THE ALTERNATIVE

In early November, Reeves seemed to be laying the ground for an income tax rate hike, warning that sticking to an election promise not to raise it would mean deep investment cuts.

So it shocked investors when government sources announced an apparent U‑turn: income tax would not go up, raising the prospect instead of multiple smaller tax hikes with unclear revenue gains.

Gilts slumped, prompting the sources to pin the reversal on better-than-expected economic forecasts.

"She built up some credibility. You saw gilt yields start to react to that, and then basically she lost it," David Zahn, head of European fixed income at Franklin Templeton, which manages $1.5 trillion of assets.

"It's a G7 economy. We can't keep on doing that," said Nicolas Trindade, portfolio manager at AXA Investment Managers, with 879 billion euros in assets.

But investors are worried that any new finance minister might not be as fiscally conservative and her departure could gravely wound Starmer's government.

"The gilt market is not in the mood to tolerate uncertainty," said Lauren Van Biljon, senior FX & rates portfolio manager at Allspring Global Investments, with around $630 billion under management.

Still, many investors favour gilts in their portfolios and benchmark 10-year yields remain noticeably beneath the 27-year peak they hit in September.

Longer-dated UK bonds have performed better than most G7 counterparts this year but the picture is less flattering if the starting point is Labour's election of July last year - with only Japanese bonds doing worse since then.

WARM WORDS FOR REEVES IN AMERICA, COLD SHOULDERS IN BRITAIN

Despite the pressures, Reeves reassured finance and business representatives during her most recent trip to the United States, including at a private meeting of the Institute of International Finance, a global association of major financial institutions, according to a source who was present.

Her stock among businesses at home is lower, largely due to last year's tax hike on employers and the lingering uncertainty.

The head of the Confederation of British Industry on Monday accused Reeves of ignoring companies on key policies, a contrast to her pre-election courtship of business.

Nervous bond markets pose the most immediate threat, followed by Labour lawmakers who could turn on Reeves if investors take fright over Wednesday's budget.

Starmer knows that he too is bound to her fate, telling the BBC in July that his government was a partnership.    

"She and I work together, we think together," he said. "We're in lock-step."

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(Reporting by Elizabeth Piper, Sarah Young, Elisa Martinuzzi, Dhara Ranasinghe, Yoruk Bahceli; writing by Andy Bruce; Editing by William Schomberg and Toby Chopra)