Market News

By James Hirai

(Bloomberg) -- UK bonds tumbled, extending a selloff triggered this week by the Labour government’s plans for vast borrowing and fiscal stimulus over the coming years.

Short-dated notes led the drop as the market priced in tighter monetary policy from the Bank of England — a response to what many investors consider to be an inflationary budget unveiled by Chancellor of the Exchequer Rachel Reeves on Wednesday.

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While the scale of the moves don’t compare with the fallout from Liz Truss’s plan for unfunded tax cuts two years ago, they underscore the tightrope Reeves must walk to keep the market on side. Labour had cast itself as a return to fiscal probity, yet it’s already seeing the bond market respond to its plans with higher borrowing costs.

“There seems to be an inflation panic at the moment,” said Evelyne Gomez-Liechti, strategist at Mizuho International. Investors are “still worried about how inflationary the budget may be, how loose it is, and how much it can change the BOE’s reaction in cutting rates.”

Two-year yields jumped as much as 18 basis points to 4.50% Thursday, a level last seen in May. The 10-year rate rose as much as 16 basis points to 4.51%, the highest level in almost a year. The market now only favors three quarter-point cuts by the end of 2025, compared with five as recently as Friday, according to swap pricing.

The Debt Management Office on Wednesday said it will sell £297 billion ($386 billion) of government bonds this fiscal year, its second-biggest target on record. While that was only slightly higher than expectations, investors pointed to official projections that imply around an extra £142 billion of borrowing over the next five years.

The funding will go toward what the independent Office for Budget Responsibility described as “one of the largest fiscal loosenings of any fiscal event in recent decades.”

This week’s moves round out a rough year for UK bonds, which have underperformed peers on the view that the BOE will lag the European Central Bank and Federal Reserve in loosening policy. A Bloomberg gauge of gilt returns is down around 3% since December, versus a 1% gain in comparable indexes of euro-area and US government bonds.

Among fiscal measures announced this week, the government increased the minimum wage and a tax on employers known as national insurance contributions. The OBR said the total package would add 0.4% to inflation over the next two years and lift the BOE rate by a quarter-point over what investors were expecting.

“With hiring becoming more expensive at a time when there are still some shortages in the labour market, the impact of these measures is likely to be inflationary,” said Felipe Villarroel, a portfolio manager at TwentyFour. “In the context of a global fixed income portfolio, there are better risk-off assets than gilts.”

Still, bids for a sale of 30-year green bonds came in at 3.15 times the amount on offer, underscoring healthy appetite to lock in the higher yields on offer. Open interest — a gauge of outstanding positions in UK 10-year bond futures — remained broadly unchanged this week, which suggests traders have not changed their bets on the future direction of gilt yields.

Fiscal Sustainability

“I’m not going to comment on market movements but the IMF said yesterday that this budget was making the right decisions to put our country back on a path of fiscal sustainability but also making the long term decisions to grow the economy,” Reeves told BBC Radio 4 on Thursday when asked about rising gilt yields.

Jessica Pulay, the chief executive of the UK’s Debt Management Office, said in an interview Wednesday she was “confident that investors will continue to absorb gilt supply over the coming years.” She said the agency tilted bond issuance more toward long-dated bonds versus the previous plan owing to strong investor demand at sales so far this fiscal year.

“The immediate concern for the market would be fiscal expansion funded by long-dated issuance,” said Mohit Kumar, chief European strategist at Jefferies. “We are not expecting any Liz Truss moment, but expect fiscal concerns to keep pressure on the long end.”

--With assistance from Anchalee Worrachate and Ellen Milligan.

(Updates prices, adds context on budget measures.)