Economic Update: UK Government Borrowing and Currency Trends

By Yoruk Bahceli, Amanda Cooper and Harry Robertson

LONDON (Reuters) – Shorter-term British government borrowing costs are set for their biggest weekly increase in over a year, while the pound faces its largest weekly loss against the euro in three months due to the Labour government's tax-and-spend budget raising inflation expectations.

Borrowing Costs and Yields

Two-year gilt yields have surged by 26 basis points this week, marking the most significant weekly rise since June 2023. Benchmark 10-year yields increased by 21 bps, reaching their highest point in a year at 4.526% on Thursday, but experienced a drop on Friday, leading to a slight rise in sterling.

Despite the notable increase in government borrowing costs and the decrease in the pound’s value, market experts suggest that the current situation is not as severe as the crisis witnessed in September 2022, which followed former Prime Minister Liz Truss's controversial budget focused on unfunded tax cuts.

Government Spending Plans

Yields have spiked as markets process the government's announcement to add nearly £70 billion to public spending annually, with over half of this covered by increased taxes and the remainder through more borrowing. The UK’s Office for Budget Responsibility (OBR) now anticipates inflation will average 2.6% next year, higher than a prior forecast of 1.5%.

Rate Predictions

Market traders foresee about 90 basis points of rate cuts by the end of next year, with expectations of a rate cut at the Bank of England's upcoming meeting, though the probability of a December cut is now below 50%.

Several investors have expressed caution, with positioning shifts leading to reduced holdings in gilts. However, firms like Vanguard, Lazard Asset Management, and AXA Investment Managers perceive buying opportunities in the current environment with higher yields.

Market Reactions

Rabobank criticized the market’s response as overstated, citing that the OBR expects the UK’s deficit to transition to a surplus within four years. Sterling revised its position, gaining 0.8% against the euro on Friday but remained poised for its largest weekly decline against the currency since late July, while juxtaposing gains against the dollar.

Investors’ positions in sterling are among the largest bullish on record, making it susceptible to declines. Recent data indicates traders are more prepared to pay to sell sterling options than to buy, indicative of potential market volatility ahead, especially with the U.S. presidential election looming.

Conclusion

UK bonds are expected to remain volatile, particularly given the current global economic climate and upcoming geopolitical events.