Written by Laith Khalaf, head of investment analysis at AJ Bell
There has undoubtedly been some relief in fixed income markets today, with bond yields falling significantly after the government ripped up most of what was left of the mini budget yesterday.
However, yields are still higher than they were before the mini-budget on 23 September, with the benchmark 10-year gilt creeping back up to just over 4% this morning, up from 3.5% the day before the former chancellor delivered his mini-budget and just under 4% following the announcement yesterday.
There are a number of reasons gilt yields may remain elevated, at least until the forthcoming fiscal statement on 31 October provides some further direction. The first is that confidence has clearly been dented in the government’s economic credentials. The rapid growth of supply in fiscal statements has led to a sharp decline in their value on global markets.
The steps taken so far by the new chancellor are helping to calm market nerves, and the publication of the OBR’s fiscal forecast will also likely help shore up sentiment. This will give investors some sort of blueprint for the future and even if it looks grisly, it will at least allow bond markets to find a new price they are comfortable with, rather than simply being faced with an information vacuum.
The second reason is that the government may still have to issue more gilts than was expected in the coming 12 months. Some of that is down to measures announced in the mini-budget which have not been withdrawn, in particular the National Insurance cut, which the Treasury forecasts will cost £6 billion by next April and a further £14 billion by the April after.
But also the energy price freeze which was re-announced in the mini-budget, and in part confirmed by the new Chancellor, which will also need to be paid for. Indeed, after the announcement of the energy price freeze, it’s likely markets were expecting some details of how this would be paid for in the mini-budget, rather than a flurry of unfunded tax cuts.
Of course, it’s possible that the fiscal statement we’re expecting on 31 October will offset some pressures on borrowing, but the Treasury is fast running out of ferrets to reverse. In order to keep borrowing at previously anticipated levels, the chancellor will have to come up with some big numbers from higher taxes, lower spending, or higher growth forecasts.
It’s possible that any or all of these could be on the cards, but it seems likely that extra borrowing will have to do at least some of the heavy lifting, in the short term at least. A greater supply of gilts would naturally be reflected in higher yields, even in becalmed markets, especially against a backdrop of a central bank that is no longer hoovering them up but is actually beginning to sell them down.
Gilt yields may also stay at an elevated level because of market expectations that interest rates will have to rise further and faster than previously anticipated. That’s because the energy price freeze and the cut to National Insurance will bolster demand, which the Bank of England is trying to restrain.
This is most likely to affect shorter dated gilts, and by extension the mortgage market, because it’s really over the next 12 months that the central bank is expected to raise rates significantly. Again, the forthcoming fiscal statement on 31 October may also include measures such as tax rises and spending cuts which deflate demand, therefore taking some of the pressure off the Bank of England to raise rates quite as steeply. That would again likely be taken positively by the gilt market.
Of course, all this takes place against the backdrop of a volatile political situation in which anything can happen in the next half hour. But as things stand, the fiscal statement on 31 October along with the accompanying OBR report look like the big bit of the jigsaw that is still missing and that markets need for a full picture of the UK’s public finances.”
