The UK’s big budget: Tax and spend plans leave bond traders scratching their heads

UK bond markets were volatile on Wednesday, as the market was initially unsure about how to welcome this Budget. We said in our Budget preview released last week that the OBR forecasts would determine the market reaction and that has been the case. After initially rallying as UK Chancellor Rachel Reeves was delivering the Budget, UK bonds reversed course. The 10-year Gilt yield is higher by nearly 3 basis points at the European close, it is trading at 4.35%, the highest level since June.

This means that the UK’s 10-year yield is higher by nearly 60 basis points since its low from September. Bond yields initially retreated as the budget’s focus on reducing the deficit by the end of the forecast period, boosted demand for Gilts. However, the OBR’s Economic and Fiscal Outlook that was released after the Budget, shifted the tone for financial markets.

Growth outlook dampens Pound

The OBR’s growth forecasts were unexceptional. The OBR expects growth to get a short-term boost from this Budget, before moderating in the medium term, as crowding out in the private sector weighs on UK growth in the medium term. This could limit GBP upside, as a positive growth outlook is important to challenge the dollar’s dominance. Instead, UK GDP is forecast to peak at 2% next year, before moderating to 1.6% in 2029. This is less than the Labour government’s target rate of growth of 2.5% per year. These GDP forecasts also suggest that the UK is unlikely to catch up with the US’s economy any time soon. The US reported Q3 GDP of 2.8% earlier on Wednesday. US-style growth rates appear to be a dream too far for the UK. Weaker than expected growth is likely to limit pound upside, and GBP/USD may struggle to extend gains significantly above $1.30 in the medium term.

BoE may also be constrained by the Budget

One upside to the lower-than-expected growth forecasts is that they could support BOE rate cuts in 2025. However, a slight uptick in the OBR’s inflation forecasts has impacted the UK’s interest rate swaps market. The implied interest rate for September 2025 is now 3.95%, up from 3.81% on Tuesday. Next week’s BOE meeting could trigger another recalibration in UK rate cut expectations for next year, so the outlook for UK interest rates could be volatile in the coming days.

UK bond market moving in line with global themes

The bond market is extremely sensitive to sovereign debt issuance right now, as government deficits are scrutinized around the world. The increase in UK bond yields this afternoon was not in isolation. Yields in the US and across Europe have also risen this week. For example, UK 10-year yields rose by nearly 3 bps on Wednesday, Italian yields were higher by 6 bps and French yields were higher by 3.5 bps. Thus, the increase in UK yields is not all down to Rachel Reeves.

The sharp rise in borrowing is a risk for Reeves

However, Reeves is embarking on a difficult path. The OBR reports that public sector borrowing is set to rise from $121.9bn last year, to $127.5bn this year, Although borrowing is set to fall back steadily to 2.1% of GDP in the longer term, the OBR predicts that  borrowing is on average £28.4bn per year higher compared to the March forecast, and the OBR states that the increase is due to changes included in this Budget. This weighed on UK Gilts on Wednesday; however, the long-term direction of UK Gilts will hinge on whether investors buy into Reeves’ view that borrowing for investment is necessary for growth.

The UK’s big budget

This is a big spending and big tax rising budget, tax rises were £40bn, and the tax burden is set to rise to a historic high of 38.2% of GDP by 2029-2030, which is 5.1% of GDP higher than pre-pandemic levels. Tax and spending levels need to be perfectly balanced to keep bond traders happy. If tax smothers growth in the UK, then the OBR’s debt forecasts could be way off the mark, which may ignite the ire of the bond market vigilantes in future.

UK not out of the woods yet

The market may not have greeted Reeves’ inaugural budget with as much glee as some had hoped, but there has not been a Truss-style panic in the bond market either. This suggests that investors are willing to give the new chancellor time. However, her decisions will continue to be scrutinized, and any missteps could ignite the ire of the bond market vigilantes. The UK has been in their crosshairs before, and they could be again.