Tom Becket, Co-CIO at Canaccord Wealth, explains how the Budget could shake gilt markets if fiscal signals unsettle investors.

In this analysis, Tom Becket, Co-CIO at Canaccord Wealth, warns that this week’s much-anticipated Budget could prove a pivotal moment for gilt markets. After the chaos of 2022, investors are braced for any hint of fiscal slippage, credibility gaps or tensions with the Bank of England, factors that could send borrowing costs sharply higher once again.

We all became rather more aware than we had been previously of how bond markets react to budgets when Liz Truss and Kwasi Kwarteng announced their mini budget in September 2022. There wasn’t anything ‘mini’ about the turmoil created by the announcement of large unfunded tax cuts – it led to fears about rising public debt and a loss in confidence of the UK government’s finances.

Although there has been a rise in borrowing costs of late, which have driven up bond yields, comparisons with 2022 are unfounded and the risk premium – which tripled after the 2022 mini-budget – are now close to average.

That said, there is undeniably a connection between fiscal policy, investor confidence and gilt markets. And with the upcoming Budget probably being the most talked about ever, what are the factors that will make bond investors jittery – what are the warning flags that could send bond markets into a tailspin?

• Relaxation of the fiscal rules/ inadequate fiscal plan: there is a bit of concern the government might ease its fiscal rules to avoid big tax rises (e.g. allowing a higher structural deficit). The prospect of higher debt will bring bond investors out in a cold sweat and could pre-empt a sell off. A lot of investors are saying that if the Chancellor doesn’t show fiscal tightening, the markets could react badly.
• Fiscal credibility – how the numbers add up: investors will scrutinise the Office for Budget Responsibility’s (OBR) forecasts and debt to GDP trajectory. If there are any questions around the funding of tax cuts (as there was with the Truss budget) and spending pledges it could reignite worries about fiscal responsibility – this could potentially impact gilts.
• Sticky inflation risks: if the Budget leans on overly rosy inflation forecasts, markets might question the realism of fiscal plans. Sticky inflation could put upwards pressure on bond yields, as investors price in higher for longer rates.
• Fiscal vs monetary tension – the Bank of England: markets will have a clear idea of how well aligned the Treasury and the BoE are. If there are any signs the Government is pulling in a different direction from the Bank’s inflation fighting stance, this could set the cat among the investor pigeons.
• Interest rate sensitivity due to shorter debt maturity: according to the OBR, the average maturity of UK debt has shortened in recent years – this means the UK is more exposed to refinancing risk. With more debt maturing sooner, the government has to issue bonds more often at whatever yields the market demands – this could be painful if yields spike.

So whatever the outcome next week, these are the signs that the bond markets will be looking out for. And given all the kite flying the government has been engaged in since the summer regarding the budget, bond markets are as in the dark as the rest of us as to the detail of what’s in Rachel Reeve’s red briefcase.