UK bonds surge as Sunak wins race to be prime minister

Gilts post historic gains amid hopes for fiscal caution under former chancellor, with more taxes looming

UK bonds posted some of their biggest gains on record as investors bet incoming prime minister Rishi Sunak will turn the page on weeks of turmoil dogging the nation’s markets and restore credibility to economic policy-making.

Short-dated notes led the rally, with the two-year yield falling by the most since 1993 after Sunak – a former chancellor who had issued a warning over Liz Truss’s “fairytale” tax cuts – emerged as the winner in the race to succeed her. The gains were supercharged as traders pared bets on future rate hikes.

Truss resigned last Thursday following a market meltdown that pushed yields to their highest in years, forced the central bank to step in to stabilise markets and eventually prompted her to backtrack on plans for vast fiscal stimulus. Investors expect Sunak will draw a line under the economic damage.

“For now it’s relief that total chaos is over,” said Marc Ostwald, chief economist and global strategist at ADM Investor Services. “His credit with markets comes from having been a steady hand as chancellor and being a polished communicator who is not going to go ‘off piste’ like the Truss government.”


For his part Sunak was quick to issue a warning on Monday that the UK faces a “profound economic challenge”.

The two-year gilt, as UK bonds are known, yield dropped 37 basis points Monday to end at 3.43 per cent. Longer notes also rallied hard, sending the 10-year yield to 3.75 per cent, the lowest since the day former chancellor Kwasi Kwarteng first announced his so-called “mini-budget”.

“Sunak is clearly the market choice, and there will be relief that we have a safe pair of hands taking over,” said Russel Matthews, senior portfolio manager at BlueBay Asset Management. “This may not last long, but there will be a honeymoon period. The experiment with an extreme neo-liberal economic policy mix is well and truly over.”

Attention is already turning to Sunak’s cabinet, with reports late on Monday that he is expected to retain chancellor Jeremy Hunt. Hunt is due to set out the government’s medium-term fiscal plan on October 31st, alongside forecasts from the Office of Budget Responsibility, the fiscal watchdog. Concern that those could be postponed has been hanging over the market.

Also looming next week is the next Bank of England meeting. While a 75 basis point interest rate hike is still fully priced, expectations of a bigger increase have faded now that fiscal rectitude appears to be returning. Policy-maker Catherine Mann on Sunday echoed recent comments by colleague Ben Broadbent, saying that “the curve was perhaps too aggressively priced”.

Still, once the initial optimism has faded attention is likely to return to the UK’s bleak economic outlook: inflation at a 40-year high, soaring interest rates, depressed consumer sentiment and a potentially severe recession. Net issuance of gilts for the next fiscal year remains vast and borrowing costs are high.

The damage done by Truss’ premiership, meanwhile, is lingering. According to James Lynch, portfolio manager at Aegon Asset Management, it could take time for some investors to venture back into the gilts market. “Risk has been cut down quite a lot and it will take time for people to come back and put it back on,” Lynch said. “We need some stability.”

The pound fell 0.4 per cent in London. It’s languishing well below the peaks reached during the first leadership contest over the summer, weighed down by huge economic headwinds ahead. The outlook for the UK’s credit score was revised to negative by Moody’s Investors Service on Friday.

“While the BOE is expected to announce a hefty rate hike on November 3rd, this may do little to support cable, as the sterling-dollar exchange rate is known, Rabobank FX strategist Jane Foley wrote in a note to clients. “The UK’s poor fundamental backdrop suggests that the pound is likely to continue to struggle.”

– Bloomberg