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. We believe that the autumn budget on 26th Nov will show a smaller fiscal hole than previously imagined levels of 20-30 BN GBP. We also believe that the recent deterioration in the labour market points to further downside risk to UK yields, as labour market softness should translate into a stronger foundation for lower inflation in 2026, alongside ongoing disinflationary progress, and an upcoming contractionary budget. Increases in the unemployment rate typically leads to lower yields over time. If the unemployment rate rises above 5.2% in the next three months, the recession threshold in UK will be triggered as per the Sahm rule. Though our medium-term target is 4% on 10yr UK gilts, for the purpose of this trade, we keep profit target at 2024 lows of 4.2 and the stop loss limit at 4.8 levels where 10yr UK gilts have repeatedly stalled multiple times in the past 2 years. Summary: We believe 10yr UK gilts are pricing in more than realistic fiscal fears as well as very conservative rate cut possibilities. Rising unemployment rate should lower inflation sooner than later and lead to more rate cuts than current market pricing. (Current Terminal rate cut pricing is 3.4% by end CY26 against current BOE policy rate of 4%) Trade Reco: BUY 10 YEAR UK GILTS (CURRENT YIELD 4.58), TP 4.20 & SL 4.80. Risks to the view: The main risks to our view comes from execution risk on the budget and political uncertainty. A perceived lack of credibility on budget measures may see further uptick in yields. A related risk is the inflationary effect of excessive GBP weakening, which throughout 2022-2024 was the link between long-end yield increases and front-end rates volatility: this type of price action is associated with a rise in UK risk premium.
