The start of a new round of gilt market carnage?

UK chancellor Rachel Reeves has now presented her first budget. Deep exhale. What does it mean for gilts? Tl;dr, it’s not a bondholder’s dream. But nor is it the stuff of nightmares.

All was going so well for gilts. When Reeves stood up to speak in parliament on Wednesday, 10-year gilts had already rallied around 8 bps from Tuesday’s closing yield highs. By the time she sat down they’d rallied a further three basis points. And as we all know, prices rise when yields fall.

However, the thing about budget speeches is that while they contain a lot of information, the order in which this information comes out makes it hard to put together a complete picture. What the gilt market really needs are numbers. Lots and lots of numbers.

These numbers come from the OBR, DMO and HMT. And they are all released after the chancellor has sat down. How did the gilt market take these numbers?

Not well.

Ten-year gilt yields jumped almost 20 basis points as folks digested the OBR’s 205 page Economic and Fiscal Outlook. They’re up another 16 bps today to trade at 4.52 per cent. How fast can bond traders skim-read? Pretty fast. But while we will undoubtedly return to the full documents in the future, almost everything we need to understand the move can be found by parsing the OBR’s 101 word summary.

Let’s take it sentence by sentence, to see how bondholder-friendly it is.

The Budget increases spending by £70 billion annually, with two-thirds on current and one-third on capital spending.

£70 billion is a lot of additional spending. It’s enough spending to juice the economy, maybe deferring Bank of England rate cuts that are baked into bond valuations.

Half is funded through tax increases which raise £36 billion annually and push the tax take to a record 38 per cent of GDP.

While a lot of bondholders are pretty Austrian when it comes to wanting small states and low taxes, this preference is unlikely to have much impact on yields. But hold on, only “half” is funded through tax increases. What about the other half?

The rest is funded by £32 billion more borrowing annually which temporarily boosts GDP growth to 2 per cent in 2026, but leaves output unchanged in the medium term.

Gulp. More gilt issuance. In fairness, we knew this was coming. But it still hurts to see it in black and white. And £32bn a year is a big number. For context, Barclays’ team had been looking for £20bn a year. Goldman Sachs’ estimate was in the same ballpark.

But the growth bump is maybe a bigger deal than the modest supply surprise.

While the fiscal rules were changed to facilitate investment, the UK budget uses a fair amount of the new space to boost current spending versus the counterfactual. According to the OBR, 2025 GDP growth has been juiced to the tune of just over 0.5 per cent by the measures. Here’s how they break down the juicing:

Let’s step back for a moment. As of Tuesday close of business, Bloomberg’s World Interest Rate Probability screen (which works off SONIA swap rates to calculate the market-implied rate of interest set by the Bank of England) was pricing the MPC to cut rates to 3.81% by September 2025.

How does this fiscal loosening change things up?

At pixel-ish time, Bank Rate is priced to fall only to 4.06 per cent by next September. With a stronger economy, bond traders reckon the UK central bank will still be cutting rates — but not quite as quickly as they thought they would be cutting it as they did before the budget. An entire rate cut has been expunged from the market’s forecast.

Should the government be sad about this? On one level, yes — very. Higher interest rates means more transfers to the Bank of England to pay interest on reserves. It also means higher issuance costs for new debt.

On another level, higher economic growth is . . . good? The idea that a chancellor should optimise policy for lower interest rates and greater bondholder capital gains is bizarre in the extreme outside of market dislocations.

And so the real sting from the earlier sentence of the OBR’s précised assessment is that this was a jam-today budget, rather than a jam-tomorrow one.

We’re coming to the end of the OBR’s 101 words. And the last sentence is pretty sharp too:

New fiscal rules, to balance the current budget and get net financial liabilities falling relative to GDP in five years, are met by small margins of £10 and 16 billion respectively.

Ouch.

When Reeves announced that she’d shift to Public Sector Net Financial Liabilities as the new measure of debt, several analysts pointed to the cavernous amounts of fiscal room she would create for herself.

Sure, the move made sense from the perspective of recognising that public investment could unblock bottlenecks to growth. But it was also important for Reeves to broadcast the intention not to use all of this new headroom, they said.

So seeing almost all of this space used up is not a great thing from a bondholders’ perspective. The OBR reckon (deep in the document) that there is only a 51 per cent chance that the new rule will be met. And that’s if an increase in employers’ national insurance rates does actually raise £25bn.

What happens if it’s missed? Higher taxes, less spending, or another change to the debt rule. The first two are fine by the bond market. The last one less so. This new set of rules is the eighth since the Charter for Budget Responsibility was set up, and changing the rules looks like the path of least resistance.

So will the gilt sell-off continue, spiralling out of control, forcing a Bank of England intervention? No, almost certainly not.

Just like the Truss mini-budget, Reeves’ budget has repriced the short-end of the gilt curve. In Reeve’s case, it has removed a rate cut from market expectations in an environment of falling inflation. In Truss’s case it added almost four hikes to market expectations in an environment of rising double-digit inflation.

The gilt market sell-off has also been given a bit of extra fizz by strong European data lifting bond yields over there as well, and a Treasury sell-off caused by Donald Trump’s improving polls.

Moreover, unlike the aftermath of the Truss mini-budget, Reeves’ meaningfully debt-financed fiscal expansion doesn’t have to worry about highly leveraged pension funds being forced into dumping gilts. These funds have now been defanged, with collateral buffers expanded.

A longer-term challenge faced by Reeves is the degree to which defined benefit pension funds’ problems have been solved by higher bond yields, reducing their appetite to lap up all the forthcoming issuance.

But there will be no LDImageddon II this autumn.