UK gilts rally as softer inflation outlook eases borrowing pressure

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UK gilts rally on inflation outlook

Highlights

UK 30-year gilt yield has dropped by 0.4 percentage points from a mid-May peak of 5.18 per cent due to softer inflation outlook.
May inflation came in softer than expected at 2.8 per cent and April output fell 0.1 per cent, leading markets to reduce interest rate hike expectations from two to one.
Political risk from the Makerfield by-election and Andy Burnham's fiscal stance impact gilt risk premiums, but easing volatility and commitment to fiscal rules could lower yields further.

Inflation outlook lifts gilt performance

As reported by Financial Times, longer-dated UK government bonds have rallied after the Iran deal and a series of softer economic releases reduced inflation concerns. The yield on the 30-year gilt has fallen by about 0.4 percentage points from its mid-May peak of 5.18 per cent, which had been its highest level since the global financial crisis.

Gilts are still slightly negative for the first half of the year, but the losses are far less severe than in 2022. The improvement is not unique to the UK, as other G7 bond markets have also rallied, though the decline in UK yields has been sharper because Britain’s public finances are especially sensitive to inflation.

About a quarter of UK debt is index-linked, roughly twice the share of the next highest G7 country. A large part of the welfare bill, including the state pension, also rises in line with inflation, meaning changes in inflation expectations feed quickly into borrowing costs.

Recent data points to an economy losing momentum. Output falls 0.1 per cent in April, inflation remains steady but comes in softer than expected at 2.8 per cent in May, and the labour market continues to weaken.

At its policy meeting on Thursday, the Bank of England keeps rates at 3.75 per cent, in line with expectations. Markets had been pricing in two rate increases this year, but that view has eased to one, and continued weak data could open the way for rate cuts next year.

Political risk still shapes market mood

The main caution for investors is the Makerfield by-election, which takes place on Thursday. At the time of writing the result is still unknown, but the contest matters because Andy Burnham, Labour mayor of Greater Manchester, is seeking to enter parliament and is widely seen as a potential challenger to Prime Minister Keir Starmer.

Investor concern centres on whether a change in political leadership could unsettle fiscal policy. Burnham’s approach has contributed to a higher risk premium on gilts, although there are signs that this period of politically driven volatility may be easing.

Burnham says he would stick to the current government’s fiscal rules if he were to become prime minister. Some expectations of higher borrowing for investment are already reflected in markets, and clearer plans that remain within those rules could support bonds.

Karen Ward of JPMorgan Asset Management argues before the Iran agreement that bearishness on gilts is overdone. In her view, political resolution and pro-growth policies that stay within fiscal limits could lower yields by as much as half a percentage point.

That does not make gilts an outright buy. UK growth remains sluggish and debt stays high, but some of the pessimism around the spring sell-off now looks excessive, and gilts could emerge as one of the larger market beneficiaries if political tensions do not worsen.

In our earlier article on the Makerfield by-election count, we covered how Andy Burnham’s push for a victory was being watched as a possible catalyst for a Labour leadership showdown and fresh pressure on Prime Minister Keir Starmer. We also noted the wider political stakes, including Reform UK’s attempt to break through in the seat and the risk that internal party tensions and possible ministerial resignations could accelerate a leadership challenge.

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