Gilts in precarious spot with UK at economic crossroads

With the recent economic spotlight dominated by President Trump’s rhetoric and Germany’s blockbuster fiscal expansion plans, Wednesday brought the UK back into focus with the latest round of inflation data and the Spring Statement from the Chancellor, Rachel Reeves.

The day started with inflation data for February coming in ahead of expectations:

• Headline CPI fell from 3.0% to 2.8% year-on-year (YoY) in February, below the 3.0% Bloomberg consensus but matching the Bank of England’s (BoE) 2.8% forecast
• Core Consumer Price Index (CPI) inflation fell to 3.5% from 3.6%, below the consensus of 3.6% (the BoE does not publish an estimate for this)
• Services CPI held steady at 5.0%, above the consensus forecast of 4.9%, though still below the BoE forecast of 5.1% for the month

Overall, this was an encouraging data print for the UK, with the drop attributed to a sharp decline in core goods prices despite persistent services inflation.

Non-energy industrial goods inflation slowed, driven by clothing and furniture which fell to -0.7% and 0.1% YoY respectively, suggesting retailers have limited pricing power following little recovery from January discounting. The upside in services inflation was attributed to strong restaurant and hotel prices, and a sharp increase in the volatile airfares component to 5.9% month-on-month (MoM) after a -19% drop in January. Meanwhile, rents declined to 7.4% from 7.8% YoY, suggesting new tenancy agreements are weakening. Within the headline, energy declined marginally MoM, while importantly food price inflation fell to 0.2% MoM from 0.9% in January – this is something the BoE watches closely as it can shift consumer inflation expectations and, in turn, drive greater wage demand.

Despite this more positive print, disinflation momentum is expected to stall in April as the energy price cap resets, the national living wage hike kicks in, and employee national insurance contributions increase. The BoE expects headline inflation to increase to 3.5% in Q2 before peaking at 3.7% in Q3. Given these headwinds, there is only so much weight the BoE will place on this more encouraging release. However, in its quarterly Monetary Policy Report published February 6, the BoE stated that this pickup in headline inflation “will not lead to additional second-round effects on underlying domestic inflationary pressures,” citing emerging slack in the economy.

The BoE will have one more inflation print (covering March) before its next meeting on May 8, but the impact of the key inflationary pressures listed above will only become visible in the May 21 release (covering April). While this print offers reassurance, the path forward remains clouded by near-term cost pressures. We suspect the BoE will use the next meeting as a window to push through another rate cut, but beyond that we expect it to remain in a data-dependent holding pattern.

Later on Wednesday, Chancellor Reeves delivered her Spring Statement. In her October budget, she set plans for £9.9bn of fiscal headroom in order to balance the budget by 2029/30. However, higher Gilt yields, lower tax receipts and a weaker growth outlook mean that buffer has evaporated and is now in the red by a magnitude of £4.1bn, meaning Reeves had to find £14bn. To tackle this, she announced:

• £4.8bn of welfare cuts
• £3.6bn reduction in planned spending
• £2.2bn from reducing tax evasion
• An additional £3.4bn from growth-boosting planning reforms

While much of the corrective action was expected and had already been leaked, markets were interested in the broader fiscal picture, and what this means for Gilt issuance and the UK growth outlook.

The UK Debt Management Office is set to issue £299.2bn of Gilts over the 25/26 financial year, slightly less than market expectations of £304bn (according to a Reuters poll). The split of the issuance was also key in determining how supply would affect the rates curve: 37% will come from short-dated, 30% from medium-maturity and 13% from long-dated Gilts, with an additional 10% from index-linked bonds and 9% still tbc. This release pointed to a heavy skew to shorter maturities compared to last year, and more so than the market was expecting.

After a bleak start to 2025, with GDP contracting by 0.1% in January against economists’ hopes of a 0.1% rise, it was no surprise that the Office for Budget Responsibility (OBR) halved its UK growth forecast for 2025 from 2% to 1%, while projecting a gradual uptick to 1.9% in 2026, 1.8% in 2027, 1.7% in 2028, and 1.8% in 2029. On inflation, the OBR raised its projected 2025 average to 3.2% (from 2.6% in 2024) before "falling rapidly" to 2.1% in 2026 and returning to the Bank of England’s 2% target by 2027 – two years ahead of its prior 2029 projection.

Gilts started the day in positive territory, buoyed by the inflation data, though gains remained muted amid caution surrounding Reeves' plans. However, following more encouraging Gilt issuance plans for the long end, the curve flattened, with the 30-year yield rallying by 6bp, the 10-year by 3bp and the two-year by 1bp. Markets are currently pricing in a 77% chance of a 25bp cut at the BoE’s May meeting but with a further cut not coming until February 2026. This reflects the market’s caution around second round pricing effects from one-off price hikes, which may halt further cuts in 2025.

The UK economy remains at a crossroads, with sluggish growth, emerging labour market cracks and persistent wage inflation – possibly tied to low labour participation – clouding the outlook. Markets will need stronger evidence of labour market weakening to cool wage pressures before pricing in more BoE rate cuts. Yet, with one-off price hikes potentially less transitory than the BoE expects (reminiscent of past miscalculations) uncertainty lingers.

This leaves Gilts in a precarious spot: they could outperform if a weakening economy and labour market spur additional easing, or they could underperform if sticky wage inflation and non-transitory pressures defy BoE expectations. With growth faltering, fiscal headroom tight, and the risk of tariffs looming, high conviction on Gilts remains limited. Given these risks, we maintain a cautious stance on Gilts until clearer signals emerge from the labour market and broader economy.