UK government bond yields are expected to decline during the rest of the year, according to analysts and investors, potentially restoring between £10 billion and £12 billion of fiscal headroom lost as borrowing costs increased since February.
The outlook comes ahead of Chancellor John Healey’s first budget on 28 October and weeks after Andy Burnham’s new government took office. Lower gilt yields would reduce the cost of government borrowing and give the Treasury greater room to meet its fiscal rules.
Investors said the latest inflation figures had strengthened expectations that the Bank of England could cut interest rates. Inflation has come in below the central bank’s forecasts in each of the past three readings, suggesting that the impact of higher energy prices on wider consumer prices may have been less severe than previously feared.
Daniel von Ahlen, a strategist at TS Lombard, said investors should “double down on gilts” over the coming months. He expects UK government bonds to perform better than comparable debt from Japan, the United States and Germany.
Markets are currently pricing in two Bank of England rate increases over the next year, but von Ahlen said cuts were more likely while the UK labour market remained weak. Lower interest rates would generally support bond prices by reducing expected future borrowing costs.
The issue is important for the Treasury because movements in gilt yields have a direct impact on government finances. The increase in yields since February has reduced the government’s fiscal headroom by an estimated £10 billion to £12 billion. A one percentage point rise in the 10-year gilt yield can add between £12 billion and £15 billion to annual government debt interest costs.
UK government bonds have been among the weakest-performing major sovereign debt markets this year, partly because Britain has been particularly exposed to the rise in energy prices linked to the conflict in the Middle East.
However, gilts performed better than some international peers in July. UK bonds recorded a flat total monthly return, compared with a 1.2 per cent decline for US Treasuries and a 0.7 per cent fall for German government bonds, according to Deutsche Bank.
Mark Dowding, chief investment officer at RBC BlueBay Asset Management, said the Bank of England’s recent policy stance could encourage investors to increase their holdings of gilts.
BlackRock currently has a neutral position on UK government bonds, while holding reduced exposure to Japanese government debt and long-term US bonds.
Borrowing costs could also receive support if the Bank of England slows its programme of gilt sales. Bank of America expects the central bank to reduce annual quantitative tightening from £70 billion to £50 billion from September.