Fiscal Crossroads: AXA IM Sells UK Gilts After Tax U-turn, Citing Credibility Gap

AXA Investment Managers (AXA IM) halved its exposure to UK government bonds, commonly known as gilts, in some global fixed-income portfolios on Friday, following news that the government has no plans to raise income tax, a senior fund manager told Reuters on Monday. This immediate and sharp reduction in position underscores deep market concern over the government’s commitment to fiscal discipline and the management of the UK’s public finances ahead of the crucial November budget statement.

The decision by AXA IM, which oversees approximately 879 billion euros ($1.02 trillion) in assets), was a direct response to reports confirming that Finance Minister Rachel Reeves had backed away from an expected income tax hike. This anticipated tightening measure had been widely priced in by investors hoping to see the government provide a significant cushion against future borrowing shocks. When that prospect evaporated, Britain’s government borrowing costs jumped on Friday. Yields on the benchmark 10-year gilt, for instance, climbed by over 12 basis points, signalling a sharp fall in bond prices and a renewed demand for a risk premium by buyers. This move by a major global asset manager signals that the political risk premium for holding UK assets is once again rising, a factor that had only recently begun to subside. The yields retraced some of that initial spike on Monday, but the fundamental message of market displeasure remained clear.

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“We are much less comfortable going into the budget,” said Nicolas Trindade, who manages global and sterling bond portfolios for the firm. Having been overweight in UK bonds before Friday in the global strategy he manages, Trindade, who invests in both government and corporate bonds, said he was now positioned neutrally, in line with bond indexes, without specifying the value of his position.

The Credibility Crisis and a Minimal Headroom

The core of the market’s unease revolves around the perceived damage to the government’s fiscal credibility. Big bond investors, many holding positions favouring gilts, had been calling on Reeves to double the margin she leaves herself to meet her own fiscal rules to £20 billion (20 billion pounds). This fiscal headroom, the difference between projected fiscal outcomes and binding debt targets, is viewed as essential for weathering unexpected economic downturns or spending shocks. Raising income tax was considered the most robust and certain method of generating this buffer. The reversal suggests that political expediency trumped fiscal prudence, triggering an immediate reassessment of the risk-reward profile of gilts.

Trindade expected Reeves to still stick to her fiscal rules, but said the way she is going to do that is “probably going to be a lot less credible than we first assumed.” The government’s fiscal rules require debt to be falling as a share of GDP in the fifth year of the rolling forecast period. Without a headline tax increase, Trindade expects the headroom Reeves leaves herself to meet the rules will be closer to £15 billion. This minimal cushion leaves the UK severely exposed.

The market’s fear is rooted in the reliability of the underlying economic forecasts. To meet the rules with a smaller tax take, the Finance Minister will be forced to rely on optimistic economic projections from the independent Office for Budget Responsibility (OBR), or on measures that lack the transparency of a direct income tax hike, suchously as freezing tax thresholds—a measure known as fiscal drag. Fiscal drag is particularly contentious because it stealthily increases the tax burden on middle-income earners as wages rise with inflation, but its revenue is less secure than a permanent tax rate adjustment.

Investors said the latest news had raised uncertainty around the budget. “The market is once again left calling into question both the chancellor’s credibility, and her ability to deliver on policy,” said Ben Nicholl, a fund manager at Royal London Asset Management. “The key risk is that any slight deterioration in the OBR’s forecast for growth or interest rates could entirely wipe out the £15 billion buffer, forcing an in-year emergency statement or a breach of the self-imposed rules.”

This environment of tight financial margins creates a constant pressure point for the gilt market. The bond market, as Ranjiv Mann of Allianz Global Investors noted, “is certainly going to apply some discipline on the government to stick to a tight fiscal stance.” In essence, the market forces the government into a continuous tightrope walk: any political deviation from a path of austerity is punished immediately through higher borrowing costs, increasing the cost of UK government debt for taxpayers.

The Shadow of the 2022 Mini-Budget

The heightened sensitivity of the gilt market to issues of fiscal credibility is a direct consequence of the September 2022 mini-budget crisis. The unfunded tax cuts announced then led to a catastrophic bond market meltdown, forcing the Bank of England to intervene with emergency purchases to prevent a systemic collapse of pension funds that rely on liability-driven investment (LDI) strategies. The swift, aggressive market reaction to the income tax U-turn, though smaller in scale, demonstrates that the scars of 2022 remain fresh.

The failure to enact the expected income tax increase is interpreted by investors like Trindade as a return to policymaking driven by political populism rather than economic necessity. This perception reintroduces what many commentators termed the “moron risk premium,” an extra yield investors demand to compensate for the risk of sudden, ill-judged policy shifts. This premium means the UK perpetually pays a higher interest rate on its debt compared to fiscally sound G7 peers, such as Germany’s Bunds or even the US Treasury market, which benefits from its status as the world’s reserve currency. The current UK debt-to-GDP ratio, which remains elevated at approximately 98% of GDP, underscores the severity of the fiscal challenge that necessitates transparent, credible consolidation plans.

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The Bull Case: Monetary Policy Dominates Fiscal Noise

In sharp contrast to the fiscal bears, fund managers at Royal London Asset Management, Allianz Global Investors, and Fidelity International maintain a bullish stance on gilts. Their conviction is anchored in the expected path of the Bank of England (BoE), which they anticipate will cut interest rates faster and deeper than markets currently price in. This investment thesis is purely monetary: lower interest rates mean lower borrowing costs across the economy, pushing bond yields down and prices up, generating capital gains for gilt holders.

The optimism is fuelled by the softening of UK economic data. While the UK’s inflation rate was elevated earlier in the year, recent data points have shown encouraging signs of deceleration, particularly in core inflation and services inflation, which the BoE watches closely. Furthermore, indicators of the labour market, such as a rising unemployment rate and a slowdown in average wage growth, suggest that the economy is losing momentum, which will pressure the Monetary Policy Committee (MPC) to pivot towards easing to avoid a deep recession.

Ben Nicholl confirmed buying five- and 30-year gilts on Friday. He favours shorter-dated bonds as he expects the BoE to cut rates faster than markets expect, making them highly sensitive to near-term policy adjustments. The shorter end of the curve typically reflects immediate interest rate expectations, and a faster BoE rate cut cycle would deliver rapid capital appreciation on these bonds.

Ranjiv Mann, portfolio manager at Allianz Global Investors, specifically favours gilts against U.S. Treasuries. The rationale here is a belief that the UK economy is slowing more rapidly than the US economy, giving the BoE more room for manoeuvre than the Federal Reserve. This disparity in economic outlook translates into a relative value play, where UK bond returns are expected to outperform US bonds in a declining rate environment. While not raising income tax reduces government policy credibility, Mann maintains that the underlying commitment to fiscal consolidation remains, and the market’s discipline will ensure it happens.

The Technical Demand Floor: LDI and Long-Duration Gilts

A significant, constant source of demand that acts as a technical floor for long-dated gilt prices comes from pension funds utilizing Liability-Driven Investment (LDI) strategies. These institutional investors require vast quantities of long-dated gilts (20-year and 30-year) to match their long-term liabilities, such as future pension payments. The demand is structural and less sensitive to short-term fiscal noise, focusing instead on duration matching.

The 30-year gilt, which Nicholl noted buying, is the workhorse of the LDI market. Its long duration (high sensitivity to interest rate changes) allows pension funds to hedge a large amount of liability risk with a relatively smaller capital outlay. Furthermore, UK regulatory changes and ongoing quantitative tightening (QT) by the BoE have created periods of scarcity, further supporting the price of these long-dated bonds. The BoE’s QT program, where the central bank sells gilts back to the market, is a significant supply shock, but the underlying LDI demand provides a necessary counterweight, ensuring that the gilt yield curve does not become excessively steep or inverted.

Another factor is the search for real returns. After years of high inflation, investors are highly focused on inflation-linked gilts, or index-linked gilts, which offer protection against future price rises. The demand for these inflation-protected assets remains robust, reflecting market uncertainty about whether the BoE can sustainably return inflation to the 2% target over the long run.

The Global Context and Supply Dynamics

The performance of gilts is also inextricably linked to the global sovereign debt complex. The UK’s borrowing costs jumped on Friday largely because the tax U-turn increased the perceived risk of higher future gilt supply to cover the shortfall, relative to the supply risk in the Eurozone bond market or the United States.

The Debt Management Office (DMO), which manages the government’s borrowing program, must issue hundreds of billions of pounds worth of gilts annually. The scale of this issuance, coupled with the BoE’s QT program, means the market must absorb an historically large volume of debt. Any wobble in investor confidence, such as that triggered by the tax U-turn, makes the DMO’s job harder and puts upward pressure on yields. For international investors like AXA IM, the trade-off becomes simpler: why hold UK gilts, with their persistent political risk and higher supply profile, when relatively safer and highly liquid alternatives, such as German government bonds, offer comparable or only slightly lower yields without the associated political uncertainty?

The global liquidity cycle also plays a critical role. As the major central banks—the Federal Reserve, the European Central Bank, and the BoE—simultaneously withdraw liquidity via QT, funding costs increase everywhere. In this environment, investors are particularly keen to avoid any assets that carry avoidable domestic risk, amplifying the negative reaction to Reeves’ fiscal retreat. The global environment rewards fiscal prudence, making the UK government’s decision to scrap the income tax hike all the more jarring for international capital flows.

Conclusion: A Pivotal November Budget

The divergence of views among major bond investors—with AXA IM signaling fiscal anxiety and other giants like Royal London and Allianz betting on monetary easing—crystallizes the dilemma facing the UK economy. The gilt market is currently caught between two powerful, opposing forces:

1. The Credibility Risk (Bearish): Driven by the government’s apparent lack of political appetite for meaningful fiscal consolidation, resulting in minimal headroom and the looming threat of breaking fiscal rules.
2. The Monetary Opportunity (Bullish): Driven by slowing inflation and a weakening economy, suggesting the Bank of England is poised for a significant and aggressive cycle of interest rate cuts.

For the gilt market to achieve stability and for the borrowing costs to trend sustainably lower, the upcoming November budget statement by Rachel Reeves must address both sides of this equation. It must deliver a credible, multi-year plan for fiscal consolidation that extends beyond the current forecast horizon, convincing institutional investors that the government is serious about debt reduction. Simultaneously, the economic forecasts embedded in the budget will need to align with the market’s view of a slowing economy, reinforcing the narrative that the BoE’s hands are tied and that rate cuts are inevitable.

Without a decisive move to bolster the fiscal accounts, the burden of supporting gilt prices will fall almost entirely on the BoE’s monetary policy, leaving the UK bond market perpetually vulnerable to political headlines and economic shocks. 

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By: Montel Kamau

Serrari Financial Analyst

18th November, 2025