ROI-Budget wary UK markets get Transatlantic balm: Mike Dolan

By Mike Dolan

LONDON, Nov 26 (Reuters) - Britain's anxious budget process reaches its climax on Wednesday when Finance Minister Rachel Reeves releases her long-awaited plans. Yet a rallying U.S. bond market is quietly offering the UK a cushion.

After months of hand-wringing about how Reeves will plug a hole in the public finances while meeting her own fiscal rules, the Chancellor of the Exchequer finally delivers the nuts and bolts.

A series of tax rises is widely expected, though better growth forecasts appear to have spared income tax - allowing her to avoid breaching an election pledge not to raise it.

Even if weeks of signalling around the plans have irritated investors, and many details will need poring over on Wednesday, many concede the basic thrust of fiscal policy is well known.

Unlike Japan, or indeed the U.S. or France, the UK budget is tightening and will likely allow relatively high Bank of England interest rates to be cut again next month.

What's less clear is the fallout. The real stakes are political and longer‑term: how the package shapes growth forecasts and business confidence and how much damage it does to an already unpopular Labour government and the reportedly shaky position of Prime Minister Keir Starmer within his own party.

But given the months of gloomy speculation, markets may already have priced in much of the pain.

For gilt investors, the key signals will come from the debt sales details: the size, timing and maturity profile of bond sales over the next year. Many, including Barclays, expect the issuance schedule to be manageable enough for markets to digest without major disruption.

More broadly, the backdrop on global bond markets - in particular U.S. Treasuries - now offers a considerable buffer to the immediate reaction at least.

Helped by a wave of fresh speculation about another year-end interest rate cut from the Federal Reserve next month, U.S. government bond yields are tumbling again to their lowest in a month.

And given the tight correlation between U.S. Treasury and gilt yields, the latter also saw a significant pre-budget swoon.

A more direct backstop is the widely expected Bank of England cut next month - itself likely an offset to the fiscal tightening and justified by a retreat in worrisome inflation.

STERLING VOLATILITY SUBSIDES

One risk in that was that a UK rate cut could sideswipe sterling. But the rising chances of another Fed cut on December 10 - just a week before the BOE's last meeting of the year - has neutralized that to some degree.

And so, even as gilt yields have fallen back on the eve of the budget, sterling has strengthened against both the dollar and euro.

Despite reports of a wave of very short-term hedging of the pound in the options market, sterling's three-month implied volatility fell on Tuesday to within a whisker of its lowest in more than a year and even one-month "vol" fell back sharply.

Parallel movements in the pound and bond prices may be a touch unnerving. Coincident moves in the other direction, for example, would raise alarm bells.

But the last-minute behavior of markets suggests an assumption that all the angst may already be in the price.

"There may be some relief ... if Reeves avoids shocking the market with excessive gloom regarding growth and productivity and if the gilt market finds some reassurance regarding debt issuance," wrote Rabobank strategist Jane Foley, adding it was uncertain how durable that might be for the pound at least.

Equity markets, often the most skittish about tax changes, have also rallied. Both the FTSE 100 blue chips and the mid-cap FTSE 250 jumped up to 1% on Tuesday too.

Pent-up relief and a suspicion of 'expectations management' over recent months perhaps explain some of the price action.

And yet a more prosaic reading might just be that Wall Street's Thanksgiving week rebound is setting a more favourable tone and the bar for negative surprises locally has therefore risen higher.

Maybe the absence of U.S. markets for much of the rest of the week will give a clearer picture as London trades on its own for a bit. But with both sides of the pond heading into a rate-cutting December, bond-market ructions may now be a tall order.

The opinions expressed here are those of the author, a columnist for Reuters

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