UK Budget: why it’s a sideshow to the BoE

UK Budget: why it’s a sideshow to the BoE

The UK Chancellor heads into the October 28^th Budget with little room for manoeuvre. Higher borrowing costs have eroded much of the government’s fiscal headroom since March, adding to the pressure to demonstrate fiscal discipline. Yet while the Budget will be an important test of investor confidence, the greater opportunity for gilt investors lies in monetary policy. Markets are pricing more Bank of England tightening than the economy warrants, leaving shorter-dated gilts attractive.

Rising yields erode fiscal cushion

We expect a relatively restrained Budget, with limited additional spending and targeted tax increases aimed at rebuilding fiscal headroom. The Chancellor’s ability to deliver this without further unsettling the gilt market will be important for confidence in the UK’s fiscal outlook.

The numbers are sobering. The Office for Budget Responsibility (OBR) estimated £23.6 billion of headroom against the government’s current budget rule in March¹. Since then, higher borrowing costs and the latest energy shock have eroded that cushion, with estimates ranging closer to £10–12 billion².

Debt servicing is adding to the fiscal headwinds, while government borrowing between April and August was already £8 billion above the OBR’s forecast³. With 10-year gilt yields above 5.4%, climbing to their highest since 2007, and interest payments expected to reach £109 billion this year, any significant new spending will require offsetting measures⁴.

We expect the Chancellor to rebuild headroom to around £15 billion, primarily through smaller tax measures focused on higher-income households and property, with some sector-specific levies. Increases in the main rates of income tax, employee National Insurance and VAT look unlikely, while larger spending commitments are expected to be deferred until next year’s Spending Review.

Whether £15 billion will be enough to satisfy investors is another question. Headroom closer to £20 billion would provide greater reassurance, given the sensitivity of fiscal forecasts to growth and interest rates. Beyond the buffer, investors will be looking to the credibility of the government’s medium-term borrowing plans. By contrast, a smaller cushion would leave longer-dated gilts exposed to renewed fiscal concerns.

A possible insurance hike, but what next?

Markets are pricing more than 100 basis points of Bank of England tightening through the end of 2027, including a near-certain hike in November, as higher energy prices revive concerns about persistent inflation⁵. Despite headline risks, there is limited evidence so far that the shock is feeding into sustained wage pressures. Further signs of cooling in the labour market, particularly wage growth, would strengthen the case for less tightening than markets currently expect. Higher borrowing costs are also already tightening financial conditions and weighing on activity, raising doubts about how much more tightening the economy can absorb.

The Bank may deliver an insurance hike in November, given resilient growth and upside inflation risks. But we would expect that move to be reversed in 2027 as the drag on growth builds. A Budget that limits additional borrowing could help support relative performance of UK 10y gilts to Treasuries, after tracking closely year-to-date. (Note: gilts and Treasuries differ in currency (GBP vs. USD), tax treatment, and liquidity/trading costs — all worth considering when comparing the two.) But we favour five-year gilts, which offer exposure to a potential repricing of BoE expectations without the same sensitivity to fiscal risks and term premium (the extra return investors want for lending over a longer period, to cover the added risk) further out the curve should the budget surprise.

A lower expected rate path would also improve the OBR's debt interest forecasts, potentially rebuilding headroom at the next fiscal event without further tax rises. That view would be challenged by a prolonged energy shock that keeps inflation elevated and validates current market pricing.

For sterling, much depends on whether the Budget reinforces confidence in the government’s fiscal approach. A credible package should provide support, although the downside risks are greater if investors judge the measures insufficient. The pound has also benefitted from Bank of England hike expectations, so a rates repricing could remove some of that support. Overall, rising gilt yields alongside a weaker currency would signal renewed concern about UK fiscal credibility.

Bottom line

The Budget will not resolve the UK’s longer-term fiscal challenges, with difficult spending decisions still ahead. But the Chancellor does not need to solve every problem next week. A credible fiscal package could ease one source of pressure on gilts, while a reassessment of BoE expectations could add further support. For gilt investors, we think the bigger risk is that markets have priced in too much tightening, not too little fiscal restraint.

• With assistance from Asbjorn Friederich, senior sovereign analyst