(Bloomberg) — UK bonds, stocks and the pound tumbled as investors dumped British assets in a swift rebuke of the new Labour government’s willingness to run up borrowing and risk faster inflation.
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The selloff propelled short-term borrowing costs to their highest level since May as investors priced in fewer interest-rate cuts from the Bank of England in response to Chancellor Rachel Reeves’ Wednesday budget. The rates repricing sent ripples across UK assets, with the FTSE 250 Index suffering its worst day since early August and the pound falling against all major peers.
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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 now discovering the bond market is willing to punish what it concludes is excessive borrowing.
“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 21 basis points to 4.53% Thursday. The 10-year rate rose as much as 18 basis points to 4.53%, the highest level in almost a year, but still just a fraction of the roughly 100-basis-point rise seen in yields over the three days that followed Truss’ budget.
The market are now split between three and four quarter-point cuts by the end of 2025, compared with five as recently as Friday, according to swap pricing.
The selloff in gilts deepened as the day wore on, ripping though other assets.
The pound slumped to its weakest since August and homebuilders led a selloff in UK shares. Taylor Wimpey Plc dropped 5.6%, the most in two years, while Persimmon Plc dropped 6.7% and Barratt Redrow Plc slid 5.9% as swaps rates that are used to price mortgages spiked.
Other yield-sensitive sectors also declined, including real estate investors, retail and utilities. A Goldman Sachs Group Inc. basket of firms with heavy UK sales exposure fell as much as 2.7%, the most in almost three months.
Heavy Supply
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 is “not a healthy repricing in gilts,” said Megum Muhic, a strategist at RBC. “It seems like the market isn’t convinced the spending measures announced will be able to drive growth in the UK, and on top of that, you have more gilt sales.”
The pain for UK assets is a shot across the bow for other nations around the world, many of which are embarking on their own chunky funding plans. Investors in US assets are bracing for whoever wins the presidential election next week to initiate an aggressive spending plan that’s likely to bolster borrowing and the deficit. Wall Street veteran Ed Yardeni warned this week that “it’s a conceivable scenario that the bond vigilantes are definitely mounting up.”
It’s also a setback for Reeves, who’d gone to considerable lengths to prepare markets for her borrowing plans, signaling her intentions while at the International Monetary Fund’s annual meetings last week.
Declining gilt prices are also politically sensitive, given how often the Labour government has slammed the market selloff triggered by Truss’ mini-budget.
When asked about the rise in gilt yields after the budget Reeves said: “The combination of our stability rule — that we will pay for day-to-day spending through tax receipts — and investment rule, to ensure that we can invest alongside business, should give markets and investors confidence to invest in Britain.”
Inflation Outlook
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.
The disorderly price action on Thursday saw UK bonds again diverge from global peers, and was exacerbated by investors getting stopped out of so-called curve steepeners, according to traders. The spread between two- and 30-year gilt yields narrowed close to 10 basis points. Some investors also closed trades for gilts to outperform versus other bond markets, they said.
“As ever in UK markets, illiquidty is exacerbating moves,” said James Athey, fund manager at Marlborough Investment Management. “With the US election now looming and the potential for more bond unfriendly news there we might struggle to easily find willing buyers so the potential for an overshoot is very real.”
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.
While headline price gains in the UK have slowed to below the BOE’s 2% target, inflation in the services sector is still running at an annual 4.9%.
“Bond markets are on edge around all things fiscal and the gilt market is no exception,” said Jack McIntyre, a fund manager at Brandywine Global. “More spending, more issuance and slightly more taxes. Not what the bond vigilantes wanted to hear.”
Still, bids for a sale of 30-year green bonds on Thursday 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.
“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, Ellen Milligan, Joe Easton and Joe Mayes.
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