UK energy package will weigh on gilts and pound, analysts warn

Investors and analysts expect sterling and UK government bond prices to weaken further as the country issues billions of pounds in debt to fund prime minister Liz Truss’s new energy package.

Under plans announced on Thursday, the government will spend about £150bn to cap energy costs at £2,500 per household for two years. The government has not said how the package will be funded but investors expect it to borrow money from the bond markets. Along with some other fiscal measures, this could mean as much as £250bn in extra gilt issuance from 2022 to 2024, according to forecasting by Barclays.

The programme is designed to help household finances across the country. But it could also complicate the long-term picture for inflation, and it will demand significant new buying interest for UK debt.

“Private investors will have to absorb the extra gilts that need to be issued,” said Stefan Koopman, senior macro strategist at Rabobank. “Truss may believe in markets, but markets don’t have to believe in Truss.”

A large uptick in spending would come at a time when the UK is already relying more on funding from abroad to support the economy. The current account deficit hit £51.7bn — or 8.3 per cent of gross domestic product — in the first three months of this year, the highest on record, according to the Office for National Statistics.

Long-term UK government bonds are already under strain. As prices have fallen, 10-year gilt yields have jumped at the fastest pace in two decades, Barclays noted, reaching almost 3.1 per cent. In early August, they stood below 2 per cent. Bond yields rise as their prices fall.

The pound slipped 5 per cent against the dollar in August, its biggest monthly fall since the Brexit referendum, and is down 14.4 per cent this year to $1.16. Much of that is down to a sweeping rally in the dollar, but the drop in the pound has outpaced that of the euro this year.

The extra government largesse needed to mitigate the energy crisis could exacerbate these trends.

The £250bn borrowing estimate “represents an extreme scenario”, said Moyeen Islam, a rates analyst at Barclays. But “simply put, the gilt market would struggle to absorb monthly sales of around £33bn without a significant repricing of yields and spreads”. That means lower bond prices and higher borrowing costs, especially as it would come at the same time as the Bank of England plans to begin quantitative tightening — cutting the portfolio of bonds it bought to support the economy after Covid struck.

“Over 2020-21, net supply of gilts averaged around £20bn per quarter once BoE purchases are taken into account,” said Islam. “Under [this new] scenario . . . the market would be asked to absorb £75bn-£100bn per quarter.”

The energy package would take the “sharpest edges off inflation” for now, reducing inflation by nearly 5 percentage points by the end of 2022, as the strain eases on household energy bills, said Koopman at Rabobank. That brings certain benefits, but it also suggests interest rate rises could be slower.

“Less cumulative tightening than currently priced in, together with elevated economic and political risks, should see the pound underperform,” said Paul Hollingsworth, chief European economist at BNP Paribas.

The BoE continues to expect the UK will slide into a recession, which would weaken the pound further. Vasileios Gkionakis, head of European FX strategy at Citi, expects it to sink to a range of $1.05 to $1.10.

“I’m really bearish on the outlook for sterling,” he said. “It all boils down to growth: interest rates are good for currency when they occur to tame very strong demand and put downside pressure on inflation. Hiking into a recession is not a good thing for the currency.”