Macro Watch - UK budget pleases bond markets; BoE to cut in December

Fiscal buffer rebuilt in response to long-term growth downgrade

UK Chancellor Rachel Reeves made her hotly anticipated annual budget announcement yesterday. In it, she laid out a host of revenue-raising measures that kick in largely later in the budgeting horizon (2028-30). Most of the measures were leaked well ahead of yesterday’s announcement and there was little surprise in the details, with the freezing of income tax thresholds to 2029-30 being the biggest change. The Chancellor also announced some spending increases, with the most eye-catching being the removal of the 2 child benefits cap (see here for more). Where Reeves did surprise – and positively – was in the amount of estimated headroom she has built up against her fiscal rules. The primary fiscal rule is that the debt ratio must be falling by year 4 of the forecasting horizon. The government now has a headroom of GBP22bn against meeting this rule (0.6% of GDP), more than double that of the previous budget (GBP10bn headroom) and approaching that of the historic average (GBP29bn). This led the Office of Budget Responsibility (OBR) to modestly raise its probability of the government meeting the fiscal rules to 59% from 54% previously – still on the low side, but an important step in the right direction in our view.

Fiscal pain is delayed, yes, but so is the forecasting pain

One major criticism of this budget has been the backloaded nature of fiscal consolidation. While it is true that this raises the risk of slippage, both in terms of execution and due to the greater degree of forecast uncertainty, we think it is appropriate in light of the nature of the changes that led to this fiscal consolidation to begin with: the downgrade to the OBR’s long-term productivity assumption. The OBR now projects long-run productivity growth of 1% annually, down from 1.3% previously. This material downgrade was clearly well overdue in light of the persistent weakness in productivity, but it also brings much more balance in terms of risks to the OBR’s forecasts than had existed previously. If anything, productivity is likely to pick up from a cyclical perspective over the coming quarters, while in the medium term, the rollout of AI poses upside risks to productivity growth. We also take a cautious view on productivity in our own forecasts, but the OBR’s downgrade at this forecasting exercise may prove to have been a backward-looking one if the impact of AI proves greater than current very modest expectations. Meanwhile, the OBR significantly raised its near-term growth forecasts thanks to stronger incoming data, with 2025 now expected to come in at 1.5% - much closer to our own 1.4% - and up significantly from the 1% forecast in March. This also clearly gave the Chancellor somewhat more leeway to raise spending (or raise taxes by less).

All told, we think the UK government did what it needed to do to keep UK bond markets on side, with 10y gilt yields having fallen 7bp since the announcement. While there is naturally some risk to this more backloaded fiscal consolidation round, it comes on top of an already considerable effort (such as the rise in employer national insurance contributions early this year) and is underpinned both by more cautious OBR growth assumptions as well as more fiscal headroom.

BoE now more likely to deliver a Christmas rate cut

The most consequential measure in yesterday’s budget from a monetary policy point of view was a fall in household energy bills, with the government now part-funding the renewables levy on energy bills. This, alongside other measures such as the now obligatory annual freeze in fuel duty, will lower inflation by 0.3pp next year. Already, financial markets had been pricing a higher risk of a December cut after somewhat more benign incoming data. Barring a big upside surprise in the November CPI data – released 17 December – we now expect the MPC to lower Bank Rate by 25bp to 3.75% when it meets the day after on the 18th. Looking beyond that, while inflation is expected to move lower in the course of 2026 – helped by generally lower energy prices – we think any flirtation with the BoE’s 2% target will prove short-lived and that inflation will move higher again in 2027. As such, following the likely front-loaded December cut and another cut in the first half of 2026, we see limited scope for the MPC to lower rates further.

Sterling recovery likely in the near term

Yesterday sterling had a volatile ride. First sterling weakened on the early release of the Office of Budget Responsibility or OBR (UK government’s fiscal watchdog) forecast. Since then, UK government bond yields have come down and sterling has recovered.

Currency markets had sold sterling for months on concerns about the budget. With the budget released and the event out of the way we think currency markets will focus on other drivers. This gives sterling room to recover in the near term. Next year we expect most of sterling’s upside to be versus the US dollar because of the general dollar weakness we expect. We think that sterling will continue to struggle versus the euro in 2026, as we think that the ECB is done with easing monetary policy, while for the Bank of England, we still expect more rate cuts (see above). Furthermore, we are optimistic about the growth outlook for the eurozone.