Bond investors are doubting the UK government’s fiscal credibility after reports that Chancellor of the Exchequer Rachel Reeves will drop a widely-expected increase in income tax in this month’s budget. UK Gilts slumped by 13 bps early on Friday as investors questioned how she would fill a large hole in the Nov. 26 budget without the tax hike. The market then reversed course to ease losses on a Bloomberg report that improved economic forecasts enabled the U-turn, but the flurry of headlines left traders struggling to get a grasp on the risks. Our own take is that Rachel Reeves might be actually looking at a smaller fiscal hole to the tune of 15-20 BN GBP. So yes she will still do tax hikes but these will be smaller tax/revenue raising efforts. Fiscal tightening is expected to weigh on GDP by 0.25-0.4% at peak between mid-2026 and early 2028, but easing monetary policy should offset some of this drag. While the autmn budget on 26th Nov might have mixed implications for UK equities, we see UK 10 year gilts as attractive at current levels of 4.58. We do not expect it to breach 4.60-4.65 levels post the budget presentation. In fact we believe these are attractive levels to buy 10yr UK gilts due to recent macro UK data. Disinflationary progress in price data has been reinforced by a deterioration in labour market quantities, which typically provide a reliable forward-looking signal for inflationary pressure. We expect 10y Gilt yields reaching 4.0% next year and 10y Gilt – Bund spreads falling to 100bp by the middle of next year from current levels of 186 bps. In summary Rachel Reeves is definitely not the next Liz Truss & we see current UK gilt elevated levels as an attractive opportunity to initiate long positions.
