UK Gilts Rally as Rate Cut Bets and Supply Shifts Align

UK government bonds are kicking off the year with a powerful rally, driven by a potent combination of cooling inflation and a government strategy to reduce long-term borrowing.

This surge has sent UK government debt, known as gilts, advancing across the curve. Benchmark 10-year gilts are on track for their largest weekly gain since October, significantly outperforming their more subdued German and U.S. counterparts.

Softer Inflation Fuels Rate Cut Expectations

For most of last year, stubborn inflation discouraged the Bank of England from cutting interest rates, even as data pointed to a weakening labor market. Now, signs are emerging that inflation is fading more quickly than analysts anticipated, prompting investors to increase their bets on central bank easing.

Market pricing reflects this growing conviction:

• Money markets are now pricing in a near-90% probability of a quarter-point rate cut by the Bank of England in April.

• The chance of a second cut by December has risen to 70%, up from less than 50% just two weeks ago.

Strategists at Goldman Sachs Group Inc. are even more bullish. They are convinced that weaker inflation and a lackluster job market will push the central bank to be more aggressive, forecasting 0.75 percentage points of cuts over the year. Calling a rally in UK rates one of their "highest conviction" forecasts, they see the 10-year gilt yield ending 2026 at 4%, which is 40 basis points lower than current levels.

Reduced Bond Supply Adds to the Momentum

Beyond monetary policy, a key shift in government debt strategy is also boosting gilt prices. According to Craig Inches, head of rates and cash at Royal London Asset Management Ltd., Britain’s move to cut its sales of long-dated bonds has helped fuel the rally, especially with waning demand from traditional buyers like defined-benefit pension funds.

Reinforcing this trend, the country's Debt Management Office will not sell any long-end bonds via conventional auctions through March. This tightening supply, combined with the prospect of rate cuts, has made UK bonds appear "very cheap" compared with peers, said Inches. "Gilts look a pretty good place to park your money."

A Sharp Turnaround from Recent Fiscal Jitters

The current rally marks a dramatic reversal in borrowing costs for the UK. As recently as early September, the yield on 10-year bonds was above 4.8% while investors worried about how the government's tax-and-spending plans would affect deficits.

Since then, a budget that raised additional revenue and the government's adherence to its fiscal rules have successfully calmed market nerves.

Looking ahead, the outlook for gilts appears strong. "We are of the opinion that the Bank of England will have to cut rates again in February," Inches stated. "This combined with the lack of supply will see yields fall, curves flatten and the UK outperform its global peers."