Market Jitters Ahead of Crucial Budget Announcement
The UK bond market is preparing for potential turbulence as Chancellor Rachel Reeves prepares to deliver her second major Budget on Wednesday. Investors are actively adjusting their gilt holdings amid concerns that the government's fiscal strategy faces intense market scrutiny, particularly following the turmoil of the Liz Truss mini-Budget era.
Market participants warn that the Chancellor has a difficult task convincing investors she possesses a credible fiscal plan, especially with rumours circulating about significant spending commitments alongside potential tax increases targeting expensive properties, pension contributions and gambling firms.
Gilt Rally Faces Reality Check
Despite recent positive momentum, longer-dated government bonds now face a critical test. The market had enjoyed its strongest performance since the COVID pandemic, with 10-year gilt yields falling over half a percentage point since January's peak, driven by improving inflation prospects and the Chancellor's commitment to fiscal rules.
This rally received an additional boost when Reeves signalled potential income tax increases, though confidence wavered when those plans were abandoned earlier this month. This U-turn has heightened concerns that the Treasury might opt for a piecemeal approach to consolidation through multiple smaller tax rises.
Investors Take Defensive Measures
The uncertain fiscal outlook has prompted some major investors to implement protective strategies. Investment firm W1M, while maintaining an overweight position in gilts, has taken out put options on sterling to hedge against potential currency downside should the Budget disappoint markets.
This strategy allows the fund to purchase pounds at a guaranteed rate against the dollar if the currency suffers a downturn following the Chancellor's announcements. Other asset management giants including Amundi and Vanguard have reportedly reduced their gilt exposure ahead of the speech.
David Zhan of Franklin Templeton expressed market concerns clearly: "The prospect of increased welfare spending along with often unreliable, future tax increases is unlikely to be well-received by the bond market. With spending happening now and revenue generation pushed further into the future, this 'spend now, pay later' Budget will be viewed as unsustainable."
These worries have been amplified by rumours of substantial new spending pledges, including a £3bn measure to remove the two-child benefit cap and additional funding for the NHS, creating what analysts fear could be an unsustainable fiscal mix.
James Carter of W1M offered a more optimistic perspective: "We remain constructive on gilts... expecting measures aimed at reducing debt costs through targeted cost-of-living support and rebuilding the fiscal buffer. These steps should be broadly bond-market friendly."
John Stopford of Ninety One summarised the market's conflicted position: "Once the Chancellor backed away from manifesto-breaking tax changes, the gilt market lost much of the confidence it had regained in the government's ability to tighten fiscal policy credibly. However, it retained its growing optimism around the path of inflation and the likelihood of a December interest rate cut."
As Wednesday approaches, the bond market appears to be expecting few positive surprises from the Chancellor, but remains hopeful that her policy choices won't prevent the Bank of England from proceeding with anticipated interest rate reductions.
