How gilt markets react to Budgets has been in the spotlight since the disastrous impact of the Truss-Kwarteng mini-Budget in September 2022. Ahead of the latest Budget tomorrow, Chancellor Hunt is under pressure to provide tax cuts where possible given the upcoming General Election.
Of course, a negative reaction from markets will increase the cost of borrowing for the Government, in a year where record issuance is expected. Interestingly, demand was five times higher than expected at HL’s gilt auction last week says Hal Cook, senior investment analyst, Hargreaves Lansdown, as he shares this analysis on what might happen to gilts after Hunt sits down tomorrow.
“Gilt markets have been under pressure for some time, due to the combination of high inflation, increasing interest rates, higher levels of government bond issuance post Covid and the Bank of England selling its gilt holdings back to the market. This has made UK gilts less attractive investments compared to cash and the increased supply has also worked against gilt prices.
There has been significant retail investor interest in gilt auctions more recently, highlighted when the demand at HL’s auction was fivefold more than expected last week. So, how events such as the Budget impact prices of gilts is more important than ever to many investors. This, coupled with increased investments into bond funds more generally over the last 12 to 18 months, makes the impact of the upcoming Budget on bond values of interest to a much wider audience than previously.
What might happen in the upcoming Budget?
Best case scenario for gilts: taxes are increased, government spending is broadly held steady or reduced. This would signal improvements to the UK Government finances, which would allow investors to consider gilts as lower risk. This would also act as tightening policies for the economy, which should put more downward pressure on inflation (higher taxes mean less money for people to spend, coupled with less government spending too). But large increases in tax or reductions to spending would be considered to reduce long term economic growth. Which, in turn, means that UK Plc would generate less income in future. This would counteract the initial perceived improvement in finances and could reduce the positive impact these policies would likely have on gilts.
Middle case scenario for gilts: either taxes are slightly reduced, and spending remains similar, or taxes remain similar and spending is slightly increased. There is some headroom in the Budget for either of these options (both effectively mean the books are more tightly balanced in future). Difficult to tell the impact on gilts in this scenario, but it’s unlikely that there would be any meaningful change in prices once investors have had chance to digest the changes being implemented. Volatility on the day is likely though.
Worst case scenario for gilts: a repeat of the mini-Budget of September 2022 – big tax cuts, or large increases in spending (or both), which push the future government finances into further debt and not being balanced. The market will not like this and gilt prices will fall, potentially quite substantially. Why? These policies would be inflationary, so interest rate cuts will likely be pushed back. This alone is bad for bond prices. But also, this would likely be perceived as unsustainable which increases risk on investors about whether they’ll actually get their money back, meaning investors would want a higher risk premium for buying gilts (so a lower price).
What will likely happen?
The current cost of borrowing for the UK Government is higher than it has been in recent years. Any negative reaction to the Budget will increase this cost, and we already know that gilt issuance this year will be higher than in the past. This adds pressure to come up with policies that do not cause a significant increase to the cost of borrowing.
That said, there is pressure to reduce taxes given the upcoming election. And there is a small amount of wiggle room for this. So, some giveaways are expected.
Gilts have lost value since the start of February and part of the reason for that is linked to the expected increase in spending / reduction to the tax take at this upcoming Budget. So, it’s possible that gilt prices won’t move massively overall, once we have all had chance to understand the implications of what gets announced on Wednesday.
But volatility on the day is likely. It’s worth noting that gilts sold off following the last Budget in November, and it could well be that this is the initial reaction as Hunt makes his speech.
Investors who have bought gilts directly and not through a fund, it’s important to remember that volatility of prices isn’t of huge importance if you are planning on holding the gilt until maturity – the price you paid at the time of investment dictates the return you will receive if you hold until maturity. But these price fluctuations are relevant if you plan on selling between now and the maturity date.”
