UK government bond yields have retraced more than 20 basis points from their mid-February peaks as investors increase exposure to gilts amid a more favourable inflation picture and bouts of equity market volatility in the United States tied to artificial intelligence.
The fall in yields included the 10-year gilt, which moved down in step with declines in US Treasury yields. A recent survey by ING of London-based bond investors found respondents were overweight UK government bonds. At the shorter end of the curve, the two-year swap rate - a gauge of market expectations for Bank of England policy - has fallen to new lows.
Market participants have pointed to a combination of diminishing inflation risks and intermittent turbulence in US equities related to artificial intelligence as factors making gilts relatively more attractive. The narrowing spread between gilt yields and swap rates has been interpreted as a sign of robust demand. In addition, the risk premium on gilts appears to have dissipated, with yields moving closer to ING's estimate of long-term fair value.
On the fiscal front, Chancellor Rachel Reeves is due to present the Spring Forecast on Tuesday. ING expects the Office for Budget Responsibility's projections to show little in the way of change, and to indicate that the government retains comfortable headroom under the fiscal rules. The announcement is expected to be low-key in tone, a contrast with last year's statement which provoked political backlash over proposed welfare changes.
Political headwinds persist. Labour's support in opinion polling has fallen to 18% according to YouGov, down from roughly 35% at the 2024 general election. The party faces a challenging set of local elections on May 7, following an impending by-election in Gorton and Denton this week.
Projections for the public finances described in advance of the forecast show the budget deficit for the fiscal year 2025 at 4.3% of GDP, below the Office for Budget Responsibility's 4.5% forecast and down from 5.1% in the previous year. The deficit is on track to decline further to 3.5% in the current year. Correspondingly, gilt issuance is expected to fall to around 250 billion from 300 billion in the current fiscal year.
Much of the projected improvement in the deficit reflects rising income tax receipts. Those higher receipts are largely the byproduct of frozen tax thresholds that, in an inflationary environment, push more taxpayers into higher tax brackets. A small reduction in net investment as a share of GDP is estimated to contribute a further 0.2 percentage points to the deficit decline.
ING has calculated that preventing the deficit from falling below 4.3% would require an increase in departmental day-to-day spending budgets of 23 billion, which it equates to a 6% real-terms uplift compared with the budgeted 1.8% rise. Beyond 2026, Treasury plans appear more austere: real-terms departmental day-to-day spending is budgeted to remain flat in 2029, implying declines on a per-capita basis.
Separately, reports indicate the government intends to raise defence spending to 3% of GDP over the current parliament, up from the budgeted 2.5% by 2027, at an annual cost of 17 billion. This planned uplift in defence outlays is set against the broader fiscal picture of slower day-to-day spending growth.
Implications for markets and sectors
- Gilt and swap markets - tighter spreads and lower yields reflect stronger demand and shifting policy expectations.
- Public finances - the projected deficit improvements and lower gilt issuance affect sovereign funding plans and fiscal space.
- Political landscape - weaker polling and upcoming local ballots add an element of near-term political risk that could influence market sentiment.