In the early days of the Iran war, UK gilts were hit hard, but they have since outperformed the government bonds of other G7 economies, with traders' focus of concern now shifting to France.
After the outbreak of the Iran war, UK gilts suffered the heaviest sell-off among the Group of Seven (G7), but they have now gradually recovered their lost ground relative to other countries. Investors are betting that the UK government will unveil a relatively low-key budget next week, which is expected to ease market worries about the country's fiscal position.
In the first few weeks after the conflict broke out this spring, the UK's borrowing costs rose the most among major economies. Traders quickly shifted from expecting Bank of England rate cuts to betting on multiple hikes, putting pressure on gilt prices. But as UK gilts have performed more strongly on a relative basis in recent months, their performance has now returned to the middle of the G7 pack.
Since the conflict began, the yield on 10-year UK gilts has risen by a cumulative 1.2 percentage points to 5.4%, while Italian government bond yields have risen by 1.3 percentage points over the same period. France has become the new focus of concern for European bond investors. Due to deteriorating public finances and political uncertainty, French borrowing costs have surged by 1.7 percentage points. Bond prices and yields move inversely, so when bond prices fall, yields rise.
Investors said the government led by UK Prime Minister Andy Burnham has signalled that it will continue the basic economic policy framework of former Prime Minister Sir Keir Starmer, while pledging measures such as scrapping the pension "triple lock". These statements have helped stabilise investor sentiment ahead of the budget announcement on 28 October.
Andrew Chorlton, chief investment officer for fixed income at UK asset manager M&G Investments, said: "In recent weeks, UK gilts have outperformed other countries, mainly based on expectations that the new government's first budget will be relatively low-key, and the market hopes this expectation will be confirmed." He added that as gilt yields have risen, M&G has now increased its allocation to UK gilts to above benchmark levels.
Jeff Mueller, co-head of fixed income at Morgan Stanley Investment Management, said: "In the current environment of severe market volatility, being able to stay low-key and not attract too much market attention is actually a good thing."
Traders expect UK Chancellor John Healey to unveil a streamlined budget that defers major spending decisions to next year's spending review. One focus of market attention is how much so-called "fiscal headroom" Healey will retain under the government's self-imposed borrowing limits. That headroom could be eroded by rising borrowing costs and inflation.
Fund managers had previously said the UK's fiscal headroom could shrink from 拢23.6 billion in March this year to about 拢14 billion, and that this change would not necessarily trigger excessive market concern. Some investors warned that the UK is in effect only postponing difficult fiscal decisions to next year's spending review. The government still faces political pressure to increase spending on defence and other priority areas.
Some investors believe France's situation is a timely reminder to the UK government of the risks that could arise from loosening fiscal constraints. During the Iran war, French government bonds were the worst-performing bond market in the G7. At the same time, the French government is also facing pressure from protesters demanding further increases in public spending.
Mike Bell, head of market strategy at RBC BlueBay Asset Management, part of Royal Bank of Canada, said: "The pressure on French government bond spreads may remind Healey of the dangers of a lack of fiscal discipline." He added: "Market concerns about the fiscal position are unlikely to disappear."
UK borrowing costs are still the highest in the G7, partly reflecting the country's persistently high inflation and the relatively high level of government borrowing in recent years. However, investors bullish on UK gilts stress that, compared with other economies, the UK's plan to reduce its fiscal deficit is relatively favourable. The real question is whether the UK can continue to advance according to the established plan.
Some investors noted that four years after former Prime Minister Liz Truss's failed "mini-budget" triggered a gilt crisis, UK politicians have formed a certain consensus on avoiding unfunded spending commitments. A large rates investor said: "Both the Conservatives and Labour have truly learned the lessons of the Liz Truss episode, while Germany, France and Japan have not learned them in the same way." He added: "Both major UK parties are discussing the trade-offs in policymaking and the need to secure funding sources for their plans."
The yield on 5-year UK gilts is currently close to the corresponding interest rate swap rate, indicating that investors are not overly worried about the scale of UK gilt issuance. By contrast, the extra yield on eurozone government debt relative to euro interest rate swaps has more than doubled this year, exceeding 0.8 percentage points and approaching peak levels during the eurozone debt crisis.
John Stopford, head of multi-asset income at asset manager Ninety One, described the market's attitude toward the UK as "cautiously optimistic". However, he said: "In the medium term, there are still many questions about how the government will balance the spending structure, taxes and borrowing constraints."
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