(Bloomberg) -- The gap between yields on UK bonds and their German equivalents is the biggest in more than a year, amid contrasting expectations for interest-rate cuts and mounting concerns over Britain’s upcoming budget.
The spread between 10-year gilt and bund yields has soared 25 basis points over the past month and is now close to two percentage points, a level last seen in August 2023. The UK yield is at 4.2%, near the highest in three months.
The bulk of the widening came after Germany’s data showed private sector business activity slumped and inflation fell below 2% last month, leading traders to bet the ECB would accelerate the pace of easing starting with a quarter-point cut next week.
The UK economy, meanwhile, has proved stronger than forecast and markets are pricing a more gradual pace of rate reductions. Higher yields also reflect mounting speculation the government will need to sell more debt to help fill a fiscal hole. Chancellor of the Exchequer Rachel Reeves will present a make-or-break budget on Oct. 30.
For Hank Calenti, senior fixed income strategist at SMBC Nikko Capital Markets, the spread widening is mostly due to the outlook for monetary policy. Markets imply the ECB lowering rates by 150 basis points by the end of 2025 to 2%, while the BOE is seen cutting 125 basis points to 3.75%.
“This is a bund issue with lots of negativity baked into it,” said Calenti, who added the move looks overdone. “That is recession pricing.”
The euro zone’s two largest economies saw private-sector business activity slump in September as Germany’s manufacturing woes worsened and France’s services industry sank. In the UK, PMI indexes still point to an expansion.
“You can see the disconnect and it shows Germany is really bad,” said Benoit Anne, a managing director at MFS Investment Management.
UK yields have also risen relative to US peers. The 10-year spread widened to 20 basis points, close to the highest in a year. The Federal Reserve is seen delivering about 150 basis points of additional rate reductions by the end of next year.
The uptick in UK borrowing costs complicates Labour’s goal to fix the public finances while also encouraging growth and investment. An internal Treasury analysis showed government plans to raise taxes to fund key spending could end up costing the exchequer money.
Several economists have suggested Reeves should change her fiscal rules to allow more borrowing for investment to boost growth rather than damage the economy with higher taxes.
“Investors fear the UK Labour government will fund increased investment with higher debt issuance rather than tax hikes,” Elias Haddad, a senior markets strategist at Brown Brothers Harriman wrote in a note.
--With assistance from Sujata Rao.
©2024 Bloomberg L.P.
