However, before we talk about Trump, we do need to discuss the UK economic outlook. The Labour government’s recent budget landed badly with business, with the rise in employers’ National Insurance contributions criticised for weakening conditions in the labour market, driving up costs and harming business and consumer sentiment.
However, it is the prospect of increased supply of UK gilts to the market which has been a bigger focus of the UK bond investor since the autumn. With the budget fiscally looser than expected, gross gilt issuance is now expected to exceed £300bn per annum, roughly £30bn more than had been anticipated. Moreover, this unhelpful backdrop was amplified by the increase in inflation expectations over the next 18 months as a response to the government’s front-loaded fiscal stimulus measures.
However, and notwithstanding the foregoing, it is the US Treasury market rather than domestic factors which have been driving the recent volatility in UK bond yields. The US Treasury market remains the world’s largest and most liquid bond market, and it continues to exert a dominant influence on all other sovereign bonds. The likelihood of higher US government borrowing under Trump and the upside risks to inflation from his trade and immigration policies have been the key driver of higher US Treasury yields.
The US Treasury market remains the world’s largest and most liquid bond market, and it continues to exert a dominant influence on all other sovereign bonds.
Whilst this narrative in the bond market has been generally negative, the rise in government bond yields in recent months has been substantial and both the UK gilt and US Treasury markets have made a reasonable adjustment to higher issuance and sticky inflation. Elsewhere, the number of interest rate cuts expected in the US and UK is now much more modest. In isolation the UK’s disappointing growth trajectory versus last autumn’s more optimistic expectations supports a more substantial reduction in UK base rates than currently discounted and, if there is a risk, it’s that the Monetary Policy Committee reduces its interest rate below the 4% level expected in the 4th quarter this year.
It is uncertainty around Trump’s policy agenda which tempers our optimism on the degree to which UK rates may ultimately fall and the extent to which gilts can rally. Whilst the UK is running a significant budget deficit with a high level of debt/GDP, these figures are dwarfed by the US, with estimates that on the back of Trump’s fiscal policies the latter could reach 140% over the next ten years. Elsewhere, whilst the markets are anticipating a modest impact from tariffs on growth and inflation, a dangerous escalation to a full-blown trade war is currently viewed as a remote possibility. This backdrop would deliver weaker growth and higher inflation which could spell trouble for long-dated US Treasuries and have a knock-on impact on long-dated UK gilts.
As yields have risen over recent months, we have become more optimistic on UK gilts, and we expect further declines in short and intermediate dated yields over the course of this year. Elsewhere, the rise in long-term gilts yields to their highest level in 27 years has prompted long-term investors to increase their allocations to the 15 year+ sector. Whilst we have sympathy with this view, we will look for greater clarity on the outlook for US public finances before recommending a bigger weight to the longest dated UK gilts.
