Rate Cuts and Rising Yields: The BoE’s Budget Dilemma

Summary:

• Disconnect Between BoE Rate Cuts and Long-Term Yields: Short-term yields may align with expected rate cuts, but long-term yields are driven by growth and inflation expectations, which could stay elevated.
• Fiscal Impact of the UK Autumn Budget: Higher fiscal spending could increase long-term yields, as bond markets anticipate sustained inflation and growth pressures.
• Strategic Focus on Short-Term Bonds: In this uncertain environment, shorter-term bonds like the 2-year Gilt appear attractive given their alignment with rate cut expectations and reduced price sensitivity to long-term yield fluctuations.

Rate Cuts vs. Long-Term Yields: The Disconnect Explained.

While short-term yields tend to move in response to central bank policies, long-term yields are influenced by expectations of a country’s nominal growth. This means that even if the Bank of England (BoE) enacts significant rate cuts, the short end of the yield curve will likely respond predictably, whereas the behavior of long-term yields remains uncertain. Long-term yields could rise if markets expect robust economic growth or persistent inflation.

The upcoming UK Autumn Budget could be a catalyst for such expectations. Should the Budget reveal higher-than-expected fiscal spending, bond markets might anticipate greater inflationary and growth pressures, likely pushing long-term yields higher. This could also slow down the BoE’s rate-cutting cycle, raising yields across the yield curve, especially at longer maturities.

In this context, maintaining a cautious stance on duration is prudent. However, shorter-term bonds like the 2-year Gilt, currently yielding 4.2%, are appealing, as they reflect anticipated rate cuts over the next two years. This yield, which is pricing in fewer rate cuts than swap markets, presents a favorable opportunity carrying less risk. With a 1-year holding period, the breakeven yield of around 8% implies that the BOE would need to resume hiking rates by over 300 basis points for this investment to incur a loss—a scenario that appears unlikely given the BoE's current outlook.

Why UK Gilt Yields May Rise Despite BoE Rate Cuts: Structural and Economic Pressures at Play.

Several structural and economic factors suggest that gilt yields may rise despite the BoE’s rate cuts:

1. SONIA Curve Expectations vs. Economic Conditions: The SONIA curve shows market expectations for the BoE to lower rates from 5% to 3.75% by late 2025. However, with real GDP growth of 0.7% year-on-year and sustained core inflation above 3%, the UK’s macroeconomic backdrop does not support aggressive rate cuts. Robust wage growth (at 5%) could keep consumer spending strong, potentially boosting growth and exerting upward pressure on bond yields.
2. Increased Gilt Issuance: This fiscal year gilt issuance is projected to increase by £15 billion, reaching £293 billion—the highest level outside of the pandemic. Over the next five years, total issuance could rise by £70 billion, which may increase gilt supply and place upward pressure on yields as the government competes for investment. This increased borrowing may reduce the attractiveness of gilts among investors.
3. Persistent Inflation Expectations: While inflationary pressures have softened, the 10-year UK breakeven rate remains around 3.5%, indicating that inflation concerns persist. This elevated level, relative to pre-Covid norms, could lead investors to demand higher yields to protect against purchasing power erosion, further complicating the BoE’s objective of managing long-term yields downward.

Will the Gilt-Bund Yield Spread Break 200bps? Autumn Budget Uncertainty and Diverging Fiscal Policies Add Pressure

The Gilt-Bund yield spread has widened considerably, highlighting the economic and fiscal differences between the UK and Europe. The spread has repeatedly tested the 200 basis point (bps) threshold, only to face resistance, indicating that market dynamics limit its ability to remain above this level for long periods.

For a sustained break above 200 bps, several conditions would need to converge, including increased UK gilt issuance alongside stable or reduced Bund issuance, as well as relatively higher inflation or growth in the UK versus the Eurozone. The UK’s Autumn Budget may drive short-term volatility and could push the spread to test this level again. However, consistent widening would likely require enduring economic or fiscal divergences between the UK and Europe.

Looking further ahead, German fiscal policy could impact this spread as well. Germany’s 2025 general election may lead to fiscal expansion, which could increase Bund issuance and support narrowing the Gilt-Bund spread. This potential increase in Bund supply could counteract some of the spread's widening, reinforcing resistance around the 200 bps level.

This is why we expect the spread to remain elevated, but not to break sustainably above 200 bps unless the Autumn Budget shows a much larger fiscal package than what markets expect.