Global Rates Strategy: Room to rally by 20bps on 10y gilts from sticking to fiscal rules

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Global Rates Strategy: Room to rally by 20bps on 10y gilts from sticking to fiscal rules

onalpolicyuncertainty). For

comparison, we think around 75-90bps of risk premium was priced into gilts from fiscal

concerns back in 2022 (Figure 2Giltmarketswerequicktopricehigherriskpremiuminresponseto202'smini-budget). If Burnham were to walk back his commitment to the

fiscal rules, markets would be quick again to price in the additional risk premium. The

extent of the sell-off would depend on the type of changes to the fiscal rules. As a

reference point, 1ppt budget balance to GDP deficit shock sees the 2s30s segment of

the gilt curve steepen the most by around 8bps followed by 2s10s and 5s30s segments

according to our curve framework (Figure 3).

A steeper curve also from inflation and a dovish BoE

Inflationary consequences of looser fiscal policy would also add steepening pressures.

The gilt curve tends to bear steepen in response to a 1ppt inflation shock unlike in the

US and Germany. The 10y has historically sold-off by around 45bps on average. Two

thirds of the rise in yields is from higher term/risk premium. We think front-end real rates

in the UK remain too high relative to the economic backdrop. We have been stopped

out of our long BoE Dec'26 trade from the recent increase in oil prices but our view

remains that the BoE's next policy move is going to be a cut. It will be the persistency of

energy price increase that will matter for the Bank. The monetary policy angle should

eventually weigh down on front-end yields. We remain long 2s10s steepeners.

Understanding average expected one-month rate and term/risk premium

Decomposing yields into average expected one-month rate over the tenor of the bond

and term premium gives us a better understanding of what is driving yields.