We consider the outlook for gilts as the Bank of England cuts rates and details emerge regarding the Labour government’s fiscal plans.

 

Today’s announcement from the Bank of England (BoE) to lower interest rates from 5.25% to 5% was a close call with policymakers ultimately voting 5-4 in favour of the reduction.

This is the first UK rate cut since 2020 but not necessarily the start of a series of cuts. Governor Andrew Bailey said the committee would move ahead cautiously, while Deputy Governor Clare Lombardelli added that the BoE’s base case for inflation is benign, but risks remain of an “alternative world” in which inflation moves higher again.

 

What does this mean for markets going forward?

 

Given the prior uncertainty, this always had the potential to be a market moving meeting and the initial market reaction was a positive one for UK government bonds, or gilts, particularly in shorter maturities which tend to be more sensitive to moves in interest rates.

Over the medium term, the outlook for UK bonds is a positive one, but there’s one major caveat and that’s bond market valuations. To put it in simpler terms, in our view the price of UK government bonds is currently high when compared to the potential profits that could be made from them and does not currently adequately compensate for the risk taken.

However, there could be better opportunities to invest in gilts in the future if market conditions change. It may be worth waiting a little bit longer to see how this unfolds.

 

Down the “black hole” – the fiscal chasm

 

Until we get some real clarity on the Budget, news headlines are likely to provide us with some market volatility, presenting opportunities to trade the UK bond market more tactically.

So far, the new Labour government is making all the right noises around balancing the books but there is plenty of scope for a mishap – a £22 billion fiscal hole being a case in point.

Encouragingly for now, the cost of some of the inflation-busting public sector workers’ pay awards will be offset by some cost-saving initiatives, including scrapping of universal winter fuel payments. That said, so far estimated savings do not fully account for the size of the fiscal hole, so we’re still awaiting further announcements, which are likely to include tax rises.

Some key dates to watch include the Labour Party Conference starting on 22 September which will provide a platform for sharing ideologies and policies. The Autumn Budget will take place on 30 October and will provide additional clarity on the government’s fiscal plans.

 

Pay goes up… inflation goes up?

 

So fiscal responsibility continues to be well communicated by the new government and sticking to a similar fiscal path would initially have fairly limited implications for the BoE.

But it’s not just about fiscal discipline, it’s also about any potential changes to the inflation outlook and how that may impact the BoE’s decision-making.

Although service sector inflation is still proving “sticky”, we’re just at the point where core inflation (which excludes the more volatile components like food and energy) is beginning to behave itself and wage pressures are easing.

The private sector makes up the overwhelming majority of the UK labour market (over 80%) and here we have seen wage growth slow in line with softer labour demand, shown below by the vacancy to unemployed ratio.

 

 

The recent announcements regarding the rise in the minimum wage and the inflation-busting approval of public sector workers’ pay awards introduce some uncertainty around the projected rate of interest rate cuts for next year. As it stands, we’re expecting a gradual easing of monetary policy conditions, potentially a cut once a quarter. However, these announcements could have implications for the timing and pace of rate cuts.

Nevertheless, it’s the private sector that is still front and centre of wage inflation in the UK. Private sector wage growth tends to lead the public sector and has scope to ease more. Still given the sensitivities for the BoE around secondary inflation effects, these public sector pay hikes might be just enough to give them pause for thought.

 

No man is an island

 

We have to remember that while the UK bond market is exposed to a number of idiosyncratic risks and opportunities, there are potentially bigger market-moving events happening beyond these shores.

As we approach the UK Autumn Statement, the US will be in the final stages of the presidential elections and we’re ready for any potential fireworks that may spill over into broader bond markets.

There remain reasons to be cautious on the UK, including uncertainties around a tricky fiscal balancing act facing the new government and the possibility of the market to be disappointed on the interest rate trajectory.

However, we would generally view bond market weakness as a buying opportunity, either outright or through curve steepening strategies (that’s where you’re positioned for shorter maturity gilts to outperform longer maturities).

More generally, with UK cash rates moving lower in line with interest rates, this might be an opportune time to lock in higher yields for longer by switching into bonds.

 
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