When France and Germany pay for their deficits, fiscal discipline becomes the "moat" of the UK bond market; investors are positioning in advance for a rebound in gilt bonds.

According to Zhitong Finance APP, several large investors are betting that UK Chancellor of the Exchequer John Healey will stick to fiscal discipline in his first budget, potentially triggering a rally in gilts (UK government bonds).

M&G, Ninety One, Mediolanum International Funds, and Raymond James Wealth Management all bought UK government bonds ahead of the October 28 budget announcement, wagering that if Healey demonstrates a steady hand on spending and borrowing, yields could come down.

Barclays UK rates strategist Moin Islam commented, “For a new Chancellor facing an uncertain backdrop, delivering an unremarkable budget might actually be the best result from a bond market management perspective. With global markets focused on Washington, Paris and Tokyo, Healey should avoid giving the market a UK-specific narrative to latch onto.”

UK’s borrowing costs are the highest among its peers

With 30-year yields at 5.8% and UK borrowing costs higher than other comparable countries, Healey faces the task of outlining Prime Minister Andy Burnham’s tax and spending policies while maintaining fiscal guardrails and avoiding “creative accounting” that would upset the bond market. Recent history shows that if investors lose confidence in government plans, it can trigger severe negative reactions.

HSBC Chief Multi Asset Strategist Max Kettner is bullish on gilts, especially longer maturities, ahead of the budget on grounds that investor concerns are fully priced in. Among developed market sovereign debt, this is the only asset class he recommends buying. According to UBS Group strategists, if the budget is smooth, 10-year gilt yields could decline by up to 20 basis points, or 0.2 percentage points.

Ninety One fund manager Jason Bobora-Sheehan has increased holdings in long-dated gilts this year, reasoning that the market has already been “through the fire” and the new government has shown “a degree of orthodoxy, or at least a concern about how gilts respond to policy making.”

The UK has long been paying the price in bond markets—for example, in 2022, then Prime Minister Liz Truss announced tax cuts funded by a large budget deficit in her “mini budget,” resulting in market turmoil so severe that she abandoned most measures, sacked the Chancellor, and resigned after just 44 days in office.

Since then, investors have responded to any sign of fiscal recklessness by pushing bond yields higher. Recent Chancellors have been eager to convince markets they would stick to fiscal rules—to borrow only for investment, and for net public debt to fall in a three-year rolling forecast period—to keep borrowing costs as low as possible.

Legal & General’s Head of Macro Strategy Chris Jeffrey said these guardrails clearly define how much the government can borrow and how large debt can grow. He noted that “frankly, this discipline does not exist in the US” and rules are much fuzzier in parts of Europe.

“I think the institutions the UK has built to underpin sustainable fiscal policy are working,” Jeffrey said.

The International Monetary Fund (IMF), which bailed out the UK during the currency and debt crisis of the 1970s, has now warned Healey to use cost-of-living support measures “with restraint,” or risk reigniting inflation. However, IMF Chief Economist Silvana Tenreyro also noted that among G7 countries, the UK stands out for its “debt-stabilizing” budget plan, which is steadily bringing the public finances back under control.

This may be beginning to change the narrative around UK debt. In July this year, on Burnham’s first day as Prime Minister, gilts were sold off after he said he would seek “any flexibility” while sticking to government borrowing and spending rules. Last year, Burnham complained that the UK “owes” the financial markets, but later retracted the statement.

Since Burnham’s election as MP, market attention has shifted elsewhere

Recently, Burnham’s commitment to fiscal rules has helped soothe the markets, with investors turning attention to other countries. Since Burnham was elected MP on June 18, paving his way to 10 Downing Street, the UK’s 10-year yield has risen about 0.6 percentage points; in the same period, French comparable bond yields rose by more than 1 percentage point due to political and fiscal concerns.

“Over the past year, the rise in UK long-term government borrowing costs has been mainly due to changes in central bank policy rate expectations, rather than shifts in perceptions of the risk of holding gilts,” said Islam.

Nevertheless, some investors believe the UK still faces significant challenges—the economy is sluggish and suffers from inflation driven by the Middle East war. Franklin Templeton Investment Management Head of European Fixed Income David Zahn said the government is “buying more time to come up with a plan,” as Burnham’s Labour Party “has no interest” in cutting benefits and other spending.

“They’re stalling for time, hoping something comes up to solve the problem,” he said.

But for now, with France in the spotlight and rising US debt levels attracting more scrutiny, the budget has shifted from a potential “stumbling block” to a possible “positive.”

“The UK’s current advantage is that it is being ignored by markets—and keeping it that way may well be the Chancellor’s job,” Islam said.