Investors are slowly coming to terms with the sheer size of the UK government’s borrowing needs over the next few years and it doesn’t look pretty.
Net gilt supply in the next fiscal year is likely headed for an all-time record, according to bank estimates. For Citigroup Inc strategists, the increase means the market needs to find twice as much new private cash to absorb it as it has over the last eight years combined.
According to the Debt Management Office, the UK’s gross financing projection over the next four fiscal years will rise almost 50% to £1tn ($1.2tn), in what Barclays Plc is calling a “significant deterioration” of the medium-term picture.
While the market initially cheered Chancellor of the Exchequer Jeremy Hunt’s package of tax increases and spending cuts on Thursday, the reality is that a staggering amount of bonds coming online may pressure the market.
Concerns are already starting to mount over the challenge of finding buyers, particularly given the Bank of England (BoE) is now shrinking, rather than expanding its holdings.
“This is an issuance challenge without precedent,” Jamie Searle, rates strategist at Citigroup, wrote in a note. “While we have been discussing the looming jump in gilt issuance for some time now, the market is yet to feel it directly. That all changes from now.”
Ten-year bonds fell for a second day Friday. At one point, yields were up 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 anxiety over the Liz Truss administration’s fiscal plan was at its peak, the supply outlook points to further weakness down the line. NatWest Markets sees 10-year yields hitting 4.3% by the second half of next year, more than a full percentage point north of where they were trading 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 pace with supply,” said Imogen Bachra, NatWest’s head of UK rates strategy, referring to Liability Driven Investment strategies widely used by pension funds. “Natural buyers, at these yield levels, may be hard to find.” The DMO is set to issue fresh debt as soon as this week with an index-linked bond sale. While the deal may do well given there’s going to be less supply of these securities in the near term, strategists still see challenges in the years ahead.
Adding to the headwinds are gilt sales by the Bank of England as it moves to reduce its bloated balance sheet. Its portfolio includes £835bn of gilts acquired over more than a decade of quantitative easing, as well as the £19bn it bought to stabilise the bond market after September’s meltdown.
There may be reasons to be less bearish on the outlook for gilts if a UK recession and easing inflation pressures enable the BoE to slow or pause its hiking cycle, according to Rohan Khanna, rates strategist at UBS Group AG.
“On the other hand, if we are wrong on monetary policy and rates have to keep rising through next year, then taking down this issuance would indeed be challenging,” Khanna said in emailed comments. The OBR cut its growth forecast to 1.4% in 2023 from 1.8% previously. It also sees inflation falling to 9.1% this year and 7.4% in 2023, though that’s way above the central bank’s 2% target.
After years of borrowing at rock-bottom rates, described as a “false paradise” by an official with the Office for Budget Responsibility, the government now has to contend with steeper financing needs and rising interest rates. “The market has just recovered from the pension fund liquidity crisis and now it may be rolling into a debt funding crisis,” said Craig Inches, head of rates and cash at Royal London Asset Management. “Even with tax rises and spending cuts, the borrowing picture is even worse than before.”
It’s another busy week for central bank policymakers with scheduled speeches including from European Central Bank Executive Board member Isabel Schnabel, who speaks at the Bank of England Watchers’ Conference.
BoE’s Dave Ramsden and Catherine Mann will also be speaking at this event. The ECB publishes the accounts of its October policy meeting. Manufacturing and services PMI numbers for November from the euro area, Germany and the UK will offer investors clues on the state of economic sentiment as will German Ifo figures.
Bond sales from Germany and Italy are set to total around €8bn ($8.3bn) according to Citigroup, which also estimates UK gilt offerings will amount to £5.5bn. That includes an inflation-linked note sale maturing in 2073 via banks.
Workers walk near the Bank of England in the City of London. Investors are slowly coming to terms with the sheer size of the UK government’s borrowing needs over the next few years and it doesn’t look pretty.