Further challenges for the UK bond market

by | Sep 27, 2022

By Karol Sindera, portfolio analyst at Neuberger Berman

While a major stimulus package should soften the near-term impact of higher energy prices, investors appear underwhelmed.

On Friday, the UK government announced its most radical package of fiscal stimulus since 1988. Overall, the package will add £291 billion (12.6% of GDP) in fiscal measures over the next five years, of which energy package is expected to be £60 billion (2.6%) over the next six months.

Authorities want to use tax deductions to boost the UK’s growth trend to 2.5% over the long run. This is in response to economists’ warnings that many British families and businesses may face significant hardship due to higher energy costs as well as labour shortages.

Critics are focusing the size of the package, saying that it is unaffordable and could trigger a currency and debt crisis: The nation’s Debt Management Office (DMO) has increased its gilts sales plan for 2022-2023 by £72.4 billion to £234.1 billion. The extra supply could be very challenging now that the Bank of England has also announced a plan to offload bonds from its balance sheet after years of buying. According to a NatWest Markets estimate made before the DMO’s revised plan, the market may have to digest three times the pre-pandemic average volume of gilts over the coming years.

A combination of higher spending, lower tax revenues and larger supply of gilts on the market could put significant pressure on the UK’s cost of borrowing. According to the Office of National Statistics, the government already paid a record £8.2 billion in August on servicing its debt, and that’s about £1.5 billion more than in August 2021. Shortly after the announcement, the market started pricing a 100-basis-point rate hike at the next BoE meeting in November. Such a reaction can only be explained by a broad loss of investor confidence in the government’s methods to boost growth.

All of this puts the BoE in a very difficult spot in seeking to maintain price stability. The added assistance seems a temporary solution for which the consumer will have to pay later. That means adding to inflation in the medium term, which could lead to a higher cost of servicing debt for longer. That, in turn, implies a significant drag on growth over time.

In sum, while the package should soften the impact of higher energy prices on the economy in the short run, the resulting potential growth in UK debt has not boosted confidence among investors.

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