Fourth – and perhaps most importantly – with the 2022 mini budget crisis still fresh in the nation’s political memory, none of the major parties are promising a radical departure from existing economic policy. Both Labour and the Conservatives have emphasised that they’ll stick to the existing fiscal rules, overseen by the independent Office for Budget Responsibility.
That doesn’t mean there aren’t going to be hard choices. Quite the opposite. Higher inflation has helped tax revenues but squeezed public spending over recent years. The Chancellor has banked the benefit of the former in successive budgets, giving away some of the windfall to households in tax cuts. But so far, public spending has largely gone unadjusted despite a period of high inflation.
This is a key challenge for the incoming government, and the room for manoeuvre is limited under existing fiscal rules. And while rules can be changed – and they may well be to accommodate more public investment – they are not seen as particularly strict by historical standards.
Still, we have to remember that this challenge is far from new. Financial markets have long since factored this in.
Our fair value model suggests ten-year Gilt yields have already been trading at a premium for much of the year, and the 5s10s slope is around 10bp, contrasting the slightly negative (inverted) slopes for USTs and Bunds. Both indicate that a term risk premium is already built into the curve, which captures some of the upcoming macro uncertainty.
We don’t expect the risk premium in gilts to increase materially over the campaign, and we therefore retain our downward bias for UK bond yields.