JP’s Journal: The Inches Corridor

It seems that the Guardian is the new ‘go-to’ newspaper to get the latest thinking from the UK government. Last week the focus was on fiscal rules – perhaps better called guidelines, as ‘rules’ suggest some permanency.

The thrust of the leaks is that the UK Budget will reveal a new fiscal framework based on Public Sector Net Financial Liabilities – PSNFL for short. This takes the concept of Net Debt and adds less liquid financial asset and liabilities, such as the student loan book and funded pension liabilities (what about the unfunded ones?).

Cutting to the chase, and factoring in some other changes already planned, this gives the Chancellor a lot of scope to increase borrowing. Assuming that there is no desire to max out the credit card, it is possible that borrowing, each year, could be £30bn-£40bn higher than anticipated. This may not translate directly into immediate gilt supply, given the lag between recording the borrowing and the actual payments on the ground – when the construction begins.

it is possible that borrowing, each year, could be £30bn-£40bn higher than anticipated

What does this mean for the gilt market? Even assuming some lags, it looks likely that 2025/2026 issuance will be at the higher end of the ‘Inches Corridor’ – named after my colleague Craig Inches – that framed the headroom for higher issuance in the £10bn-25bn range. If the expected issuance is higher than that, we believe that investors are going to get twitchy.

There is a credible story for the Chancellor to tell and some economic realism is welcome. The UK has underinvested in its infrastructure. Spending decisions are too short term and capital projects are sacrificed for more immediate requirements. However, this is not without difficulties. First, higher taxes will hit growth in the short term; raising employers’ National Insurance is a tax on jobs. Second, there will be a meaningful time delay between tax increases and the economic benefits of the investment. Third, it needs to be productive investment and the UK’s record is not encouraging.

The cynic may say that we have been here before. Putting in ‘guard rails’ and listening to the Office For Budget Responsibility (OBR) may sound good now but will these new rules stand the test of time – or the next economic squall? Once a higher debt threshold is outlined there will be a temptation to push towards the boundary as things get tough.

Ultimately, it will be markets that define what is feasible from a debt perspective. The recent underperformance of gilts is a natural consequence of uncertainty about the government’s plans. But the toning down of the headroom for debt levels in the last 48 hours is a good indication of government nervousness. It is much easier to lose economic credibility than to regain.

Yields on 10-year UK gilts rose 10bps, ending the week just below 4.25% and 50bps higher than six weeks ago. The trend in most markets was for higher yields, with the US 10-year rate also closing at around 4.25%. Credit markets continued to outperform as credit spreads generally moved lower. Issuance has picked up in recent weeks but has been absorbed by investors.

On the geopolitical front, Israeli’s strike on Iran saw the oil price fall below $70 barrel – as the response was not focused on oil facilities nor as widespread as feared. Are markets being too complacent? Possibly, but there seems to be no shortage of oil at the moment. Cheaper petrol ahead for UK motorists? Let’s see what happens to Fuel Duty.       

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.