Investors are beginning to reconcile the sheer size of the UK government’s borrowing needs over the next few years, and it’s not looking pretty.
The net supply of gilts in the next fiscal year is likely to be heading for an all-time record, according to bank estimates. For Citigroup Inc. strategists, the surge means the market needs to find twice as much new private money to absorb than it has in the past eight years combined.
According to the Debt Management Office, the UK’s gross financing forecast is set to increase by nearly 50% to £1 trillion ($1.2 trillion) over the next four financial years, which Barclays Plc. speaks of a “significant deterioration” in the medium-term picture.
While the market initially cheered Chancellor Jeremy Hunt’s package of tax hikes and spending cuts on Thursday, the reality is that a staggering amount of bonds coming online could weigh on the market. Concerns about the challenge of finding buyers are already growing, especially given that the Bank of England is now shrinking rather than adding to its holdings.
“This is an unprecedented issuance challenge,” wrote Jamie Searle, rates strategist at Citigroup, in a statement now everything is changing.”
Ten-year bonds fell for a second day on Friday. At one point, yields rose more than 20 basis points from a low on Thursday, the biggest jump since late October.
While they have fallen from over 4.50% since concerns over the Liz Truss government’s budget plan peaked, the supply outlook points to further weakness. NatWest Markets expects 10-year yields to hit 4.3% by the second half of next year, more than a full percentage point north of where they traded on Friday.
“It’s hard to see an environment where the usual buyers of gilts – foreigners and LDI – feel compelled to increase demand to keep up with supply,” said Imogen Bachra, Head of UK Rate Strategy at NatWest, referring generally to liability-driven investment strategies employed by pension funds. “Natural buyers may be hard to find at these yield levels.”
The DMO will issue new bonds already this week with a sale of index-linked bonds. While the deal could go well as there will be less supply of these securities in the near term, strategists still see challenges in the years to come.
Additional headwinds come from the Bank of England’s gilt selling as it seeks to trim its bloated balance sheet. Its portfolio includes £835bn of gilts purchased over more than a decade of quantitative easing, as well as the £19bn it bought to stabilize the bond market following the September meltdown.
According to Rohan Khanna, rates strategist at UBS Group AG, there may be reasons to be less pessimistic about the outlook for gilts if a UK recession and easing inflationary pressures allow the BoE to slow or halt its rate hike cycle.
“On the other hand, if we’re wrong on monetary policy and need to keep interest rates rising into next year, then it would indeed be a challenge to reverse this issuance,” Khanna said in emailed comments.
The OBR lowered its growth forecast to 1.4% in 2023 from a previous 1.8%. It also sees inflation falling to 9.1% this year and 7.4% in 2023, although this is well above target the central bank is 2%.
After years of borrowing at rock-bottom rates, which an official at the Bureau of Fiscal Responsibility dubbed a “false paradise,” the government is now grappling with increased funding needs and rising interest rates.
“The market has just recovered from the pension fund liquidity crisis and could now slide into a debt financing crisis,” said Craig Inches, Head of Rates and Cash at Royal London Asset Management. “Even with tax hikes and spending cuts, borrowing is worse than before.”
In this week
- It’s another busy week for central bank policymakers with speeches scheduled including European Central Bank Executive Isabel Schnabel speaking at the Bank of England Observers Conference
- BOE’s Dave Ramsden and Catherine Mann will also speak at the event. The ECB publishes the annual accounts of its monetary policy meeting in October
- November manufacturing and services PMI numbers from the eurozone, Germany and the UK will provide investors with clues to economic sentiment, as will Germany’s Ifo numbers
- Bond sales from Germany and Italy are expected to total around 8 billion euros ($8.3 billion), according to Citigroup, which also estimates UK gilt issuance will total £5.5 billion. This includes selling an inflation-linked note due 2073 through banks