UK Chancellor John Healey’s budget appears to leave some room for UK government bonds and sterling to modestly outperform, at least in the short term, argues Aviva Investors’ chief UK economist Vasileios Gkionakis.
Read this article to understand:
- What the UK budget tells us about the state of the government’s finances
- Why the chancellor looks to have put off some tough spending decisions
- What it means for UK government bonds and sterling
Chancellor of the Exchequer John Healey used his first budget to reassure financial markets that he intends to keep a grip on public sector borrowing.
Healey’s budget speech has been met with a neutral to mildly benign response by the UK government bond market as it avoided any fiscal shock for now.
Ten-year gilt yields fell by 2 basis points after the announcement, while sterling has been broadly flat.
Healey said his plans would leave fiscal headroom – the amount by which spending could rise or taxes fall without breaching the government’s self-imposed fiscal rules – of £15 billion in 2029-30.
The separate rule requiring public-sector net financial liabilities to fall is met with a £24 billion margin. While that headroom is down from £23.6 billion in March, the decline was broadly in line with financial markets’ expectations.
Higher inflation and interest rates have weakened the government’s underlying fiscal position. The UK budget watchdog, the Office for Budget Responsibility (OBR), estimates debt-interest spending will be £15 billion higher this year than it expected in March and £12 billion a year higher on average over the medium term.
The budget adheres to both fiscal rules. The current budget moves into surplus within three years, meaning revenues fully cover day-to-day spending, while public-sector net financial liabilities fall later in the forecast.
Government borrowing remains sizeable but declines over the forecast. Policy decisions add £8 billion to borrowing in 2026-27 and £4 billion in 2027-28. But later tax rises and spending restraint reduce borrowing in subsequent years. Across the forecast as a whole, the package is broadly neutral.
Importantly, the Debt Management Office’s (DMO) revised issuance mix for 2026-27 appears relatively benign for long-dated gilts because it reduces supply of longer-dated securities and increases supply of short and medium-term ones.
The budget also provides targeted support for households and businesses, including a £2.6 billion energy payment and business-rates relief. This is partly funded through targeted tax rises on banks, savings and property income, and higher Machine Games Duty.
The budget was clearly designed to calm rather than excite financial markets
Healey was always likely to claim the government was set to meet its fiscal rules and look to avoid the need for a large increase in long-dated gilt supply. The budget was clearly designed to calm rather than excite financial markets, but the important implicit message is that big decisions have been deferred for the future.
The likelihood is that next year’s annual spending review will see Healey having to confront some tough choices.
The OBR’s assumptions imply that spending on unprotected departments would fall by 2.6 per cent a year in real terms over the final three years of the forecast. Spending would need to be £11 billion higher in 2031-32 simply to prevent those budgets falling in real terms from 2028-29. The government will have to reconcile these pressures with commitments on health, schools and defence.
The OBR raised its 2026 growth forecast to 1.2 per cent from 1.1 per cent, but cut its 2027 forecast to 1.0 per cent from 1.6 per cent. It expects inflation to peak at close to four per cent in early 2027, with no real earnings growth in 2027 or 2028.
Healey delivered his speech against a backdrop of soaring government borrowing costs. Ten-year gilt yields recently hit their highest level since 2007 while the yield on 30-year bonds is at a 28-year peak.
As in other developed nations, UK bond investors have been fretting over the state of the country’s finances and a spike in inflation caused by the war in Iran.
Financial markets are predicting the Bank of England will lift interest rates aggressively over the coming months, with four quarter-point hikes priced in by next July. But, while inflation may be uncomfortably high, the underlying economy is fairly subdued, and we think interest rates seem unlikely to rise as much as the market has priced. We therefore see some scope for UK government bonds to outperform international peers between now and next year’s government spending review.
Sterling may also draw some short-term support from the budget, although we are not bullish on the pound looking further ahead. This is in part because we do not believe UK interest rates will need to rise by nearly as much as the market is indicating, and in part due to the broader cyclical strength of the dollar.1
