The market may not have greeted UK Chancellor Rachel Reeves’ inaugural budget with as much glee as some had hoped, but there has not been a Truss-style panic in the bond market either. This suggests that investors are willing to give the new chancellor time. However, her decisions will continue to be scrutinized, and any missteps could ignite the ire of the bond market vigilantes. The UK has been in their crosshairs before, and they could be again, writes Kathleen Brooks, research director at XTB.
UK bond markets were volatile when the budget was released, as the market was initially unsure about how to welcome it. After initially rallying as Reeves was delivering the budget, UK bonds reversed course. The 10-year Gilt yield is higher by nearly 3 basis points at the European close, it is trading at 4.35%, the highest level since June.
This means that the UK’s 10-year yield is higher by nearly 60 basis points since its low from September. Bond yields initially retreated as the budget’s focus on reducing the deficit by the end of the forecast period, boosted demand for gilts. However, the OBR’s Economic and Fiscal Outlook that was released after the Budget, shifted the tone for financial markets.
UK bond market moving in line with global themes
The bond market is extremely sensitive to sovereign debt issuance right now, as government deficits are scrutinized around the world. The increase in UK bond yields this afternoon was not in isolation. Yields in the US and across Europe have also risen this week. For example, UK 10-year yields rose by nearly 3 bps on Wednesday, Italian yields were higher by 6 bps and French yields were higher by 3.5 bps. Thus, the increase in UK yields is not all down to Rachel Reeves.
The UK’s BIG budget
This is a big spending and big tax rising budget, tax rises were £40 billion ($51.9bn), and the tax burden is set to rise to a historic high of 38.2% of GDP by 2029-2030, which is 5.1% of GDP higher than pre-pandemic levels. Tax and spending levels need to be perfectly balanced to keep bond traders happy. If tax smothers growth in the UK, then the Office for Budget Responsibility’s (OBR’s) debt forecasts could be way off the mark, which may ignite the ire of the bond market vigilantes in future.
BoE may also be constrained by the budget
One upside to the lower-than-expected growth forecasts is that they could support Bank of England (BoE) rate cuts in 2025. However, a slight uptick in the OBR’s inflation forecasts has impacted the UK’s interest rate swaps market. The implied interest rate for September 2025 is now 3.95%, up from 3.81% on Tuesday. Next week’s BoE meeting could trigger another recalibration in UK rate cut expectations for next year, so the outlook for UK interest rates could be volatile in the coming days.