Bond markets have the final say, and things could get volatile

Ahead of today’s Budget, UK gilt markets are braced for a potentially volatile reaction as investors assess whether the Chancellor can convincingly place public finances on a sustainable path. Oliver Faizallah, Head of Fixed Income Research at Charles Stanley, outlines the key risks and scenarios for bond markets — from the prospects of a “gilt-positive” fiscal package to the dangers of a credibility-damaging misstep that could trigger a renewed sell-off.

Oliver Faizallah, Head of Fixed Income Research at Charles Stanley, comments:

“Bond markets will be watching very closely, ultimately being the arbiter as to whether the Chancellor has done enough to put the country’s debt on a sustainable path. The Budget will lay out the government’s plans for how much they will be taxing and spending, and the timeline over which they plan to implement these plans. Economists estimate that Rachel Reeves needs to raise £30 billion to plug the hole in government finances and increase the fiscal headroom in case the fiscal outlook darkens again.  

“Over the past couple of months, gilt yields have rallied (yields falling) on the back of promises of the imposition of harsher income taxes, which planned to boost government revenues and efficiently plug a substantial portion of that fiscal hole. Additionally, we have had supportive inflation prints, and revisions to OBR forecasts showing a smaller-than-expected fiscal hole which encouraged gilts to rally further.  

“More recently, we have seen a partial reversal of this rally following reports the government has dropped plans to raise income tax, instead opting to freeze income tax thresholds and raise revenue by taxing a large number of smaller income streams. This reversal gave markets the view that the government is not willing to cause party upset and make difficult decisions. In addition, questions around there being less overall fiscal tightening raised concern over how quickly the BoE can and will act when cutting interest rates.  

“Given the sell-off across the yield curve, there is room for investors to be positively surprised by the Budget should sufficient headroom get added, and if we see a greater, more front-loaded rise in taxes than current market expectations.”

Expectations and possible outcomes 

“There are multiple outcomes which could surface tomorrow. We are hoping for a ‘gilt positive’ Budget, whereby despite more favourable forecasts from the OBR on the size of the fiscal hole, the chancellor will see this as a good opportunity to take steps to shore up public finances, rather than pare back politically unfavourable tax cuts.  

“In practice, this would mean finding other credible ways, in lieu of income tax increases, to raise revenue to increase the fiscal headroom. This would see big ticket revenue drivers by imposing measures on income and national insurance contribution thresholds, pension relief, and a reliance on more spending cuts.  

“The risk is a ‘gilt negative’ Budget, where the revisions on forecasts from the OBR will see the chancellor rely on smaller, back-loaded measures to boost revenue, which would further play into concerns about the UK’s fiscal credibility. A smaller fiscal tightening, which does not result in an increase in tax revenue of at least £25bn, will see the Chancellor left with very little, or no fiscal headroom, boost near-term inflation and raise investors’ interest rate expectations, ultimately resulting in a Labour party backlash which could see the Chancellor replaced by someone even less committed to fiscal discipline.  

“This would risk a fiscal doom-loop of higher gilt yields leading to higher gilt yields. Ultimately, a large gilt sell-off, where yields notably rise, could see the government reverse their plans and even result in the BoE stepping in to calm the market, as seen in the 2022 mini-budget fiasco.  

“We could get a more moderate combination of the two scenarios, whereby there is a mixture of larger and smaller taxes, of which some are implemented sooner, and others backloaded. This could raise enough revenue to see a decent amount added to the Chancellor’s fiscal headroom, while not causing a large increase in expected near term inflation. This would appease Labour party peers enough for the Chancellor to keep her job. In this scenario, we would expect gilt yields to either moderately drift downwards or move sideways. The government would then have to stomach higher borrowing costs for some time, and continue to balance spending cuts, taxes, and party politics.  

“The spending side of the Budget has seen less coverage in the run-up to tomorrow, and perhaps this is misplaced. Overall, however, the gilt market will be focused on the sustainability of the whole package, and the assumption goes that whatever tax rises are introduced, the spending side of the equation won’t put the books out of kilter.”

Bond markets have the final say, and things could get volatile  

“Higher taxes and additional fiscal headroom would be positive for gilts, which may see the long end of the curve drift down as the fiscal risk premium falls. In addition, adverse effects on GDP growth and inflation from tight fiscal policy, may result in short end yields falling as interest rates are forecasted to move lower by investors.  

“If markets are not convinced, we will likely see a larger amount of the market selling gilts. This will push up yields, making it more expensive for the government to borrow and worsening its fiscal position further – creating a fiscal doom loop. The level at which gilt yields settle will directly impact the level of interest the government pays. In the most recent fiscal year, it spent over £100 billion on interest payments, an increase from roughly £40 billion a year before the pandemic.  

“The more money that goes to interest payments, the less there is for general spending. In addition, an increase in today’s spending, alongside delayed taxation could stoke inflation fears. If inflation is expected to remain elevated, investors will price out expectations of BoE interest rate cuts over the course of the next 12 months. Compared to the US Treasury market, the gilt market is relatively small. This means sentiment from the Budget can have quite a large impact on yields, increasing volatility. We have also seen a reduction of steady demand from local pension funds, which tend to be stable, long-term investors, to more ‘flighty’ market participants, such as retail investors, asset managers and foreign investors. These investors are more likely to sell if not convinced by the ability of the UK government to improve their fiscal credibility.”