Investors in British government bonds (gilts) are on edge ahead of the new Labour government’s first budget announcement on October 30. Finance Minister Rachel Reeves is set to reveal her fiscal agenda, the first of its kind in 14 years under a Labour administration. While many anticipate a significant rise in debt issuance, bond markets seem cautiously optimistic that Reeves will avoid pushing the country’s borrowing to unsustainable levels, a key concern after former Prime Minister Liz Truss’s infamous “mini-budget” debacle in 2022, which severely shook market confidence.

Investors’ Concerns Over Borrowing Costs

Britain’s borrowing costs have surged ahead of the budget, signaling apprehension from investors. On Monday, benchmark 10-year gilt yields reached their highest point since the July 4 general election, while 30-year yields, which serve as a proxy for long-term budget risks, saw their largest premium over German bonds in two years. Analysts suggest that a budget heavily focused on increased borrowing could weigh on market sentiment, but most investors don’t expect Reeves to mirror the extreme policies of her predecessors.

Reeves, who has pledged to improve public services and boost infrastructure investment without resorting to significant tax hikes, may introduce changes to how the government calculates public debt. This move would potentially enable her to increase borrowing while still adhering to her pre-election promise of reducing debt as a share of national income. These anticipated fiscal maneuvers could allow the government to borrow an additional £50 billion, a considerable sum relative to the £278 billion in gilt issuance planned for this year.

Market Reaction: Gilt Sales and Investor Sentiment

Despite these uncertainties, some investors are holding back on gilts. The Bank of New York Mellon reported that its clients sold £3 billion worth of gilts last month, marking the largest outflow since Truss’s budget-induced bond market crisis two years ago. This has led to concerns that a more relaxed fiscal rule could muddy the distinction between capital investment and day-to-day government spending, which Reeves has promised to keep balanced.

Benjamin Nabarro, chief UK economist at U.S. bank Citi, noted that demand from international investors for British gilts has significantly decreased. “We have seen a material reduction in demand from international real money,” he said, pointing to the uncertainties surrounding the upcoming budget and the impact it could have on gilt prices.

The Impact of Previous Fiscal Missteps

Reeves’s forthcoming budget carries additional weight due to the legacy of the economic turbulence triggered by the Truss administration in 2022. Truss’s unfunded tax cuts, combined with a sharp rise in borrowing, led to a major sell-off in gilts, sending yields soaring and prompting the Bank of England to intervene to stabilize markets. This episode remains fresh in the minds of investors, leading many to approach the new budget with caution.

Simon French, chief economist at Panmure Liberum, echoed this sentiment, suggesting that investors may stay on the sidelines until there is more clarity on Reeves’s fiscal discipline. “Until you see the proof of that, you probably will stay out [of gilts] for a little while and see if she’s going to be true to her word,” French said.

However, other investors see potential in the current situation. Some analysts believe that gilts now represent a buying opportunity. Cosimo Marasciulo, head of fixed income absolute return at Amundi, Europe’s largest asset manager, said, “We see new interest from investors to look at the UK market,” adding that short-dated gilts appear to offer the best value at present.

Similarly, HSBC described gilts as “cheap outright and cross-market,” while Barclays advised clients that “pessimism over the budget is too high and valuations look cheap.” The median forecast in a Reuters poll suggests that 10-year gilt yields will fall to 3.85% by the end of 2024, down from the current level of 4.17%. This predicted drop would result in a larger price gain for gilts compared to U.S. Treasuries or German bonds.

External Factors and Economic Outlook

While the upcoming budget is a significant factor influencing gilt prices, it is not the only one. Global economic conditions, especially in the United States and Europe, have also played a role. Since late August, the yield spread between 10-year gilts and U.S. Treasuries has remained relatively stable, but the gap between gilts and German bonds has widened by nearly 0.25 percentage points. This shift is driven by expectations that the European Central Bank (ECB) will cut interest rates more aggressively to support the eurozone’s struggling economy.

In contrast, the Bank of England (BoE) has been slower to signal rate cuts. Chris Jeffery, head of macro strategy at Legal & General Investment Management, attributed the weakness in gilts to the UK’s persistently high inflation and stronger-than-expected economic growth, both of which are delaying the BoE’s moves to lower rates. “For me, the driver here hasn’t really been the fiscal [policy] at all,” Jeffery said. “The Bank of England is being less eager to embrace interest rate cuts than everyone else.”

Markets are currently pricing in a 1.2 percentage point reduction in BoE rates by the end of 2025, compared to 1.5 percentage points expected from both the Federal Reserve and the ECB.

Modest Budget Changes Expected

Much of the market’s relative optimism about gilts stems from the belief that the changes Reeves is likely to introduce will be modest. Goldman Sachs economists predict that the government’s annual investment spending could rise by £10 billion if Reeves reverts to a debt definition used before 2022, which adjusts how losses by the Bank of England are recorded. A more significant change in targeting a reduction in public sector net financial liabilities could lead to an additional £20 billion a year in investment spending.

However, even these figures fall short of the extra fiscal flexibility—ranging from £16 billion to £53 billion—that would be available under different interpretations of the debt rules.

Ben Zaranko, senior economist at the Institute for Fiscal Studies (IFS), emphasized that while certain changes to the way the government accounts for its assets and liabilities may appeal to a government looking to increase investment, these measures could give a distorted view of the country’s financial health. “You can’t sell off a school in a financing crisis,” Zaranko said, cautioning that including hard-to-value assets such as public infrastructure or natural resources in fiscal calculations may not provide a clear picture of solvency. “Some people argue you should put natural assets in there too. I love bumblebees as much as the next person, but you can’t sell off a bumblebee.”

Conclusion

As the UK prepares for its first Labour budget in over a decade, investors are keeping a close eye on Rachel Reeves’s fiscal strategy. While concerns about increased borrowing and potential market disruptions persist, many analysts believe that the upcoming budget will strike a balance between necessary public investments and fiscal discipline. Investors are cautiously optimistic that the new government will avoid the pitfalls of the past, but much will depend on how Reeves navigates the complex challenges of managing public finances while maintaining market confidence.

With gilt yields fluctuating and global economic conditions in flux, the reaction of bond markets to Reeves’s budget will be critical not only for the UK’s economic outlook but also for its broader reputation among international investors. All eyes are on the October 30 announcement to see if the Labour government can deliver a fiscal plan that both stimulates growth and ensures long-term financial stability.

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Photo source: Google

By: Montel Kamau

Serrari Financial Analyst

17th October, 2024