UK government bond yields are expected to decline over the rest of the year, according to analysts and investors, potentially helping the Treasury recover between £10 billion and £12 billion in fiscal headroom lost as borrowing costs increased since February.
The outlook comes ahead of the 28 October budget and only weeks after Andy Burnham’s new government took office, with John Healey preparing for his first budget as chancellor.
Investors said signs of easing inflation could increase the likelihood of Bank of England interest rate cuts. The outlook for US monetary policy and Japan’s expansionary fiscal plans could also make UK government bonds more attractive compared with debt issued by other major economies.
Daniel von Ahlen, a strategist at TS Lombard, urged bond investors to increase their exposure to gilts in the coming months. He expects UK bond prices to perform better than government debt in Japan, the United States and Germany.
Markets are currently pricing in two Bank of England rate increases over the next year. Von Ahlen believes borrowing costs could instead fall if weak conditions in the labour market continue.
The movement in gilt yields has significant implications for the government’s finances. The increase in borrowing costs since February has reduced the Treasury’s room for manoeuvre under its fiscal rules by an estimated £10 billion to £12 billion. A one percentage point rise in the 10-year gilt yield would increase the government’s annual debt interest bill by around £12 billion to £15 billion.
UK government bonds have been among the poorest-performing major government debt markets this year. Britain has been particularly exposed to higher energy costs linked to the conflict in the Middle East. However, recent inflation figures have come in below Bank of England forecasts, indicating that higher oil prices have had a more limited impact on wider prices than initially feared.
Gilts showed signs of improvement in July. UK government bonds recorded a flat total monthly return, while US Treasuries fell 1.2 per cent and German bonds declined 0.7 per cent, according to Deutsche Bank.
Mark Dowding, chief investment officer at RBC BlueBay Asset Management, said the latest Bank of England meeting had not made him more positive about the immediate outlook for gilts. He noted that the central bank’s cautious approach to monetary policy could encourage investors to increase their holdings.
BlackRock currently holds a neutral view on gilts, while maintaining reduced exposure to Japanese government debt and long-term US bonds.
Japanese bonds have struggled as the country prepares for higher interest rates and the government pursues tax cuts and increased investment spending.
UK borrowing costs could also receive support if the Bank of England slows its programme of gilt sales. Bank of America analysts expect annual quantitative tightening to fall from £70 billion to £50 billion from September.
