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UK Bond Turmoil Aftermath Has Plenty to Keep Traders on Edge

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The dust from the UK budget fiasco that almost broke the gilt market has barely settled. Yet, bond traders are gearing up for fresh volatility, with a rate hike, central bank bond sales and the government’s much-anticipated budget coming in quick succession.

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(Bloomberg) — The dust from the UK budget fiasco that almost broke the gilt market has barely settled. Yet, bond traders are gearing up for fresh volatility, with a rate hike, central bank bond sales and the government’s much-anticipated budget coming in quick succession.

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First up is the Bank of England policy meeting Thursday, which will be key to establishing whether a collapse in rate-hike expectations has gone too far, or perhaps not far enough. It’s a complex calculation, with inflation at a 40-year high, a recession looming and a return to austerity in the cards under new Prime Minister Rishi Sunak. 

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The repricing of where interest rates are heading has been fueled by dovish comments from BOE policy makers after bets topped 6% at one point. Borrowing costs haven’t been that high in more than 20 years. There’s also been a dramatic shift in the government’s plans, which have flipped from an inflation-boosting splurge to spending cuts and tax hikes. The benchmark rate is now seen peaking below 5%.

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There’s even growing uncertainty about what happens to the BOE rate on Thursday itself, when a three-quarter percentage point hike is fully priced, according to swaps tied to central bank meeting dates.

ING Bank NV and Citigroup Inc. are among those arguing the move could be smaller, potentially further easing pressure on UK bonds after the meltdown triggered by the unfunded tax cuts under the former government. 

“The bank meeting is going to be very important for investors, not only in terms of whether they go 50 or 75 basis points, but also in terms of the outlook,” said Mark Healy, a fixed income portfolio manager at AXA Investment Managers. “It will signal the direction of the bank going forward.”

Investors are also on the watch for clues to when the BOE may add long-dated debt to its active gilt sales, a process know as quantitative tightening, or QT, that’s due to begin Tuesday. Those notes, which were at the center of the recent market turmoil, have been excluded for now. 

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“Anything around the QT program is very important,” said Chris Jeffery, head of rates and inflation strategy at Legal & General Investment Management. “They’ve said they’re not going to touch the long end for now, but will they tell us about the timetable? The market is looking at that quite carefully. It’s the big swing factor now.” 

The government’s budget plans will also influence the BOE’s thinking. They’ll be unveiled on Nov. 17 amid speculation there could be billions of pounds of tax increases and spending cuts on the way.

Fragile Market

In a sign of how quickly sentiment can turn, UK bonds were swept up in a global bond sell-off Friday as faster-than-expected inflation in Germany, France and Italy made traders reassess the likelihood of a dovish pivot by the European Central Bank. 

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Issuance by the country’s Debt Management Office in the coming weeks, including a gilt syndication on Nov. 8, will give an insight into investor demand. DMO Chief Executive Robert Stheeman warned of the “challenging” environment as it prepares to tackle the biggest net sales of bonds in history.

Still, 30-year gilt yields are about 150 basis points lower compared with late September, while measures of implied volatility — though still high — have also eased. The pound has rebounded to almost $1.16 against the dollar, having at one point dropped to a record-low $1.035.

Sunak isn’t just seeking to fill a hole in the public finances. He also wants to re-establish confidence after the chaos that followed his predecessor Liz Truss’s proposals, which ultimately led to her resignation after mere weeks in office.

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The relative calm since he took over persisted even after he delayed the much-anticipated fiscal statement from Oct. 31. “The change of government has brought back credibility,” said LGIM’s Jeffery. “There is less necessity to act with haste.”

From the BOE itself, there have been blunt comments about market bets going too far. Catherine Mann, the central bank’s most prominent hawk, said that pricing was overly aggressive, and Deputy Governor Ben Broadbent warned that tightening on that scale would be economically damaging.

That tone may be echoed on Thursday. Bank of America says the BOE will lower both its growth and inflation forecasts.

“The market may have sighed a breath of relief that the architects of the mini-budget have now left,” the strategists wrote in a note to clients. “But this will not provide a long-term solution. The fault lines in the UK economy and in politics run deep.”

This Week

  • Commerzbank strategists expect about €18 billion of supply via sovereign auctions from France and Spain, among others. Germany will conduct the final linker as well as the final green bund auction this year, they wrote in a note to clients
  • Euro area inflation data is due on Monday. Bloomberg Economics sees the headline figure jumping to 10.8% for October from 9.9% September, following a very sharp increase in Italian energy bills. There are also plenty of central bankers due to speak throughout the week, including ECB President Christine Lagarde

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