Chief UK economist, Vasileios Gkionakis, gives his initial reaction to Chancellor Rachel Reeves’ Budget, offers an assessment of the state of the economy and public sector finances, and outlines what it might mean for interest rates and sterling-denominated assets.
Read this article to understand:
- What the UK Budget means for government bonds
- Why weaker data should now pave the way for faster rate cuts
- Why adverse political developments remain a key risk
Chancellor Rachel Reeves' Budget has been calmly received by the UK government bond market as investors signalled their belief that her efforts to restore fiscal headroom and tackle the country’s deficit were reasonably credible.
Gilt prices rose slightly, with the yield on the ten-year benchmark down six basis points after the announcement while sterling appreciated. Both gilts and the pound had fallen in recent days after Reeves appeared to backtrack on a plan to raise income tax.
In her speech, Reeves stood by the government’s fiscal rules and said the freezing of income tax thresholds, along with other tax raising measures, will boost the fiscal headroom – the amount by which spending could rise or taxes fall, without breaching self-imposed fiscal rules – to £21.7 billion from £9.9 billion.1
The chancellor failed to significantly cut spending, meaning the increase in the headroom is almost exclusively the result of tax increases.
Reeves has sidestepped major pitfalls and will likely welcome the market’s calm response. She avoided making big promises she couldn’t keep. That said, tax hikes arguably remain the wrong prescription given the UK’s cyclical and structural backdrop. Still, this was not an unfriendly Budget for bonds.
What this means for interest rates
Reeves’ decisions to cut energy bills from April will lower 2026 inflation by some 40 basis points, which should enable the Bank of England (BoE) to cut interest rates faster. Recent falls in annual inflation, and the fact services inflation led the decline in October, have strengthened the case for the BoE to cut interest rates again in December.
While financial markets expect rates to fall to around 3.3 per cent by November 2026, the risks appear skewed towards an even lower endpoint.
The UK economy has slowed materially since the first quarter – with a reduction in private sector activity driven by weaker business investment, subdued consumption growth and rising unemployment.
This has been depressing wage growth and given the weaker economic backdrop, the risk is that the BoE could deliver more easing than currently expected by markets.
These economic developments and progress on inflation reinforce the case for additional BoE easing and suggest some further upside potential for gilts which are trading well below fair value on our model.
The Budget has likely managed to appease recent frustration among Labour MPs, but risks for a leadership challenge will remain in place as we head to the May local elections. Political developments could unsettle markets, but for now we think the bias is for lower rates in the UK. The pound may benefit in the immediate future but is likely to underperform looking further ahead given the likely path of UK interest rates.
