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Gilts have staged a strong rally this week, driving down the UK government’s borrowing costs as chancellor Rachel Reeves looks for tax rises and spending cuts in next month’s Budget.
The yield on the country’s benchmark 10-year debt, which moves inversely to prices, has fallen 0.14 percentage points this week to 4.53 per cent. That puts the yield on track for its biggest weekly decline since April, despite a small rise on Friday.
Global sovereign bond yields have been dragged lower in recent sessions by intensifying expectations of rate cuts from the US Federal Reserve.
Investors said market-friendly messages from the Treasury, including Reeves saying she would consider public spending cuts alongside tax increases — and her allies indicating she would increase the amount of “headroom” against her borrowing rules — were also helping.
The “right noises are coming out”, said Gordon Shannon, a fund manager at TwentyFour Asset Management. “The mention of spending as part of the calculations was a surprise given the last few months’ political struggles.”
The rally was fuelled earlier this week by comments from Andrew Bailey, the Bank of England governor, drawing attention to a softening labour market that could help to bring down inflation in future.
Traders now think the Bank of England will make a quarter-point interest rate cut by February, sooner than they were pricing last week.
But Huw Pill, the BoE’s chief economist, struck a more hawkish note on Friday, saying “the need to recognise the stubbornness of inflationary pressures is becoming more pressing”.
Data next week is expected to show that UK inflation rose to 4 per cent in September, according to economists polled by Reuters. While some BoE rate-setters believe this is largely due to the one-off effects of food and energy price increases, and tax decisions taken last year, others worry there has been a more lasting shift in the behaviour of workers and businesses, making wage and price pressures persistent.
Pill said this made it “important to guard against the risk of cutting rates either too far or too fast”.
His comments followed a similarly hawkish message from Catherine Mann, an external member of the BoE’s Monetary Policy Committee, who said in Washington this week that there was “very clear upside evidence of inflation being above target, staying sustained above target”.
It is unclear whether the rally in gilts will help reduce the size of the fiscal hole that Reeves will need to fill next month to meet her rule of running a current budget surplus by the end of the Office for Budget Responsibility’s forecast period in 2029-30. The shortfall is estimated by the Institute for Fiscal Studies at about £22bn, of which £5bn is due to higher borrowing costs.
That is because the OBR has not yet disclosed which 10-day window it is using to measure the market prices that underpin its forecasts.
Jack Meaning, UK chief economist at Barclays, said the recent rally in gilts could reduce the direct hit from higher borrowing costs by about £2bn if it is captured by the observation window.
But Robert Wood, chief UK economist at the consultancy Pantheon Macroeconomics, said going by the timetable the OBR had followed in the run-up to last year’s Budget, the window is likely to have closed.
The OBR this week declined to say what period it is using this year, adding that it often published this information two weeks before the Budget.
The UK still has the highest borrowing costs in the G7, thanks to persistent inflation and concerns over its debt load. The 10-year yield hit a 16-year high of 4.93 per cent in January as concerns over the UK’s near-record gilts issuance combined with a global sell-off in bond markets.
Gilt investors have called on the government to build a larger buffer against its fiscal rules than the slim £9.9bn of margin left at the past two fiscal events.
But some investors contrast the UK positively with the policy direction in other big bond markets.
“There is, I think, a path to fiscal consolidation. I don’t see that in France or the US,” said Luca Paolini, chief strategist at Pictet Asset Management.