Philip Hammond, the UK’s Chancellor of the Exchequer, delivered today’s budget statement against an appealing political backdrop. Growth is holding up better than expected, revenues are exceeding expectations, and near-term borrowing estimates have been revised down to £51.7 billion for the fiscal year just ending and are expected to fall to just £16.8 billion in five years’ time.
Underpinning this is a stable economic backdrop in which UK real GDP growth is forecast to remain in a relatively narrow range of 1.5% to 2% in coming years. Relative to the forecasts made in November, the near-term data have all been revised up, although the long-term end point is little changed.
A Brexit budget, if not in name
Given the benign backdrop, and after seven years of fiscal austerity, the temptation to ease the pace of deficit reduction will have been considerable. This is especially the case as the UK is about to embark on potentially tricky negotiations to exit the European Union, and a strong economy would undoubtedly help the government navigate this process.
However, rather than opting for looser fiscal policy, the Chancellor has continued with the plans set out last November, retaining a tight lid on spending and bringing the deficit down to a point whereby he would have the flexibility to raise spending later should the economy slow more than expected.
While the Chancellor may have avoided making even one reference to Brexit during his one-hour speech, this budget was clearly set with those negotiations in mind. The UK is about to enter a period of potential uncertainty, and the greatest gift the Chancellor can provide to the government is economic protection. By holding back spending today, that is precisely what he is aiming to do.
What does this mean for UK bonds? In the immediate aftermath of the Chancellor’s speech, UK bonds sold off modestly; however, this has more to do with stronger overseas data than the budget itself. UK yields remain low in absolute terms and relative to other markets: 10-year gilt yields are at 1.3% and 30-year gilt yields are at 1.8%, with market participants expecting the Bank of England to leave interest rates unchanged into 2019.
In the event the economy does slow, the Bank of England will likely be constrained in loosening monetary policy given the expected rise in Consumer Price Index (CPI) inflation to above its 2% target. Higher government spending – which the Chancellor is allowing himself room for – is a more likely policy response. Given that outlook, UK yields look rich.
Mike Amey is PIMCO’s head of sterling portfolio management and a regular contributor to the PIMCO Blog.