UK Market Outlook: From the BoE to the Budget—What Investors Need to Know

Stay tuned after the conclusion of the podcast for additional important information. Visit PIMCO.com for expert insights on navigating volatility, inflation, and the evolving macro-outlook for UK investors.

In this episode of Fixing Your Interest, Rupert Harrison CBE—Senior Adviser for the UK at PIMCO and former Chief Economic Adviser to the UK government—and Dr. Peder Beck-Friis, Economist in PIMCO’s London office, examine the forces shaping the UK’s investment landscape. They discuss how Bank of England policy, fiscal decisions, and market cycles are influencing asset allocation, with a special focus on gilts and strategic positioning.

RUPERT HARRISON: Hello, I'm Rupert Harrison, and I'm joined by Peder Beck-Friis. And we are going to be talking about all things UK, markets, macro, and we've got a budget coming up, which seems to be a source of major speculation. It's a bit of a seasonal trend in the UK these days. I mean, I guess the starting point is that for us, the UK’s a bit like a poster child for PIMCO's, a lot of PIMCO's global themes. So when we think about politics driving economics rather than the other way around, highly indebted governments being quite constrained. So maybe not being so able to use fiscal policy the next time things go wrong.

The reset higher in yields, meaning that central banks do have ammunition and also meaning that global bonds are quite attractive relative to particularly relatively expensive equities. The UK exhibits all of those things. How would you pet a kind of place the UK on all those themes relative to other G10 countries, for example? And what does it mean for the path of policy over the next few years in the UK? 

PEDER BECK-FRIIS: Yeah, I think that's right, you know, a lot of the themes that we've been speaking about for a long time, very much playing out in the UK to some extent. There's nothing new really in the UK. I mean, politics really have been driving economics in the UK for a long time. Brexit, one example, but it's also true on fiscal policy.

A lot of governments, now getting more concerned around that debt sustainability, but we really had the shock in the UK three years ago, under Liz Truss.Of course, UK lost a little bit of fiscal credibility temporarily and then ever since been trying to rebuild that. I think on the debt sustainability points, you know, it's true that it looks vulnerable in the UK I think broadly manageable on the current policy is not as bad, I think, as in the US or France. 

But I do think that the UK is facing more tight sort of constraints on fiscal policy. You know, UK does not issue the global reserve currency like the US does, growth here is much weaker, in France, you know, the currency region is much bigger than in the UK. I think the good news, if you think of the policy mix, is that there's a lot of monetary policy space. Remember before the pandemic, we lived in this era where you had, you know, much more fiscal space, but very little monetary policy space because interest rates were so low.

And now, you know, almost seeing the flip side of that, not much fiscal policy space, but a lot of monetary policy space given that interest rates are so high. And I do think that has implications for fixed income and financial markets. But certainly on the fiscal side, lots of constraints. So curious to hear your views here, Rupert, given your background in policy making, do you think that the policy makers in the UK understand these constraints? Do you think that this influences the thinking in the government at the moment? 

RUPERT HARRISON: Yeah, I think they absolutely do. And I think you mentioned some of the reasons for that. And I think that actually the contrast you made with the US and France is a really good one. So those are both countries where the political debate has not really internalized any market pressure.

In the US that's partly 'cause there isn't any market pressure. So the US is running budget deficits, six to 7% of GDP, and yet the 10-year treasury is at 4%, yield curve have steepened a bit, but you know, I think that our view would be the US dollar, despite a lot of talk at the end of the dollar, the US dollar remains the global reserve currency. Treasuries remain the global reserve asset for at least the next five years, maybe longer, and so there isn't really market pressure and you can see that reflected in the political dynamics. 

There isn't really a constituency within US politics making the deficit the driving factor. France is similar, where you have started to see some market pressure in France, you know, spreads on French bonds and now, you know, maybe relative to buns crossing above Italy, which is sort of politically embarrassing for France, but it hasn't really worked its way into the political debate.

And you still see that with a very fragmented parliament, it's very difficult to get that majority together to actually do something about high deficits. The UK is very different because we kind of had our, you know, booster jab for fiscal credibility because of the trust episode in 2022, which really kind of seared itself on the political memory. And so I think all the politicians are now very nervous about, you know, a repeat of that 'cause they saw how disastrous that was for the government. 

And even more recently, we had some quite stark events in the UK, so there was a sort of soap opera day where Rachel Reeves was pictured crying in the House Commons, and the gilt market sold off sort of 20 basis points, which is quite a big one day move. And that was because investors suddenly thought maybe Rachel Reeves was going to resign or maybe she was going to be replaced as chancellor and replaced by someone who had less commitment to the fiscal rules. So, and I think, again, everybody noticed that. And so I think that there isn't a lack of will.

I think the politicians totally understand what needs to be done. The interesting thing even maybe is, you know, over the last couple of weeks that spread even further out the political spectrum. So I think when people look ahead, maybe four or five years in the UK, they might think about reform, which is currently leading all the opinion polls.

And at the last election they had quite a fiscally, shall we say, loose approach to the public finances, but even in the last couple of weeks actually, they've been backing off that and saying, no, we're not committed to 90 billion pounds of tax cuts anymore and we're going to have a credible budget. And so I think that the booster jab has even got into the kind of reform bloodstream and as a result, I think gilt markets have maybe noticed that.

PEDER BECK-FRIIS: Yeah. No, I think that's right. And yeah, I think the, if you look at the last few weeks, we've seen a pretty strong rally in gilt yields, meaning the gilt yields have come down. I think that part reflects sort of a stronger message from the government that more fiscal tightening is coming, but also on the macro side, you know, we've seen somewhat softer inflation print, somewhat softer labor market print. So, interest rates have come down a bit.

RUPERT HARRISON: Do you want to go into that? 'cause actually that's been one of PIMCO's views for some time that we like gilts. We like owning gilts, in portfolios, particularly around the five-year point, which is very responsive to the policy expectations. And I think that for a long time people have been saying, well, the UK looks like a bit of an outlier.

Quite sticky inflation, certainly relative to other European countries where inflation is back to target. Can you expand a little bit on like, why we still like gilts, why is it, why have gilts done so well over the last couple of weeks? And, you know, do we still like them from here? 

PEDER BECK-FRIIS: Yeah, no, look, I think, you know, we've been speaking about fiscal credibility and fiscal policy, and I think that clearly has an impact on gilt yields, but I think the key reason why interest rates in the UK are high, is because inflation is high. And you're right, you know, if you just look at spot inflation now in the UK somewhere between three and a half, 4% that is higher than in the rest of the world. So I think the outlook for government bonds in the UK very much depends on the outlook for inflation.

And I think here we have, you know, somewhat more perhaps sanguine view on inflation than the rest of the market. The, yeah, I think the key reason why inflation's high in the UK is because of regulatory and tax related policies that we're seeing over the last six months, clearly that will filter through and fade into...

RUPERT HARRISON: So you mean, so that's things like the employer national insurance rise, that's utility bills, going up.

Speaker 1: VAT on private schools, in January and et cetera. And that mechanically lifted inflation. But if you think, you know, fast forward a few quarters fast forward, you know, a year, you know, the labor market is weakening, we're seen that pretty clearly wage growth is slowing. There's some part of the inflation basket that is very weak now. Rent inflation, I'll give you one example, has fallen very, very sharply over the last few months.

So I think there are good reasons to expect inflation to continue to normalize, you know, forecasting inflation, you need to be very humble. But I think there are good reasons to expect inflation to, you know, converge close to the 2% target by the end of next year. And frankly, if you think about what's going on in the rest of the world, we are seeing this inflation, perhaps the US is an outlier because of the tariffs.

RUPERT HARRISON: Why should the UK be an outlier? 

PEDER BECK-FRIIS: Why should the UK be an outlier, especially in the context of the tight fiscal policy that we are seeing. 

RUPERT HARRISON: So in that context, how low do you think interest rates can go in the UK in this cycle? 

PEDER BECK-FRIIS: Well, look, I think that's a million-dollar question for us, for fixed income investors, for financial markets. We can debate, of course, the near term path for Bank of England in terms of if they're going to cut this quarter, next quarter. But the million-dollar question is, you know, how low will they go?

And this is an economics, what's called a neutral rate, a normal policy rate, where will the interest rates sort of average over a cycle? And again, lots of uncertainty. You need to be humble. Our best guess is that it's somewhere, you know, perhaps 275, you know, plus minus, a quarter a percent or so, financial markets at the time of this recording pricing the Bank of England to cut down to about 3.4%.

RUPERT HARRISON: That's a big gap.  

PEDER BECK-FRIIS: That's a big gap. And if, you know, bank of England, cuts down to, you know, three or even below, that would, you know, mechanically lead front end short term interest rates to full. And that is where we think, you know, if you think of government bonds in the UK where the most attractive part is really in the sort of five-year part of the curve, because it's an expectation from us that the Bank of England will cut more aggressively.  

RUPERT HARRISON: Gilts have done well because you said like wage data's been coming down, inflation looks like maybe it's normalizing, but there could be more to go because actually that neutral rate could be lower.

And that is really interesting because actually that's something that comes up a lot when we are talking to clients in the UK, that people go, remember back to 2012, 2013, when you could get 5% plus interest rates like either even sometimes just on your bank deposits, but certainly short term gilts, you know, look like a very nice place to park some money, but with rates coming down, that's no longer true, but the interesting thing is that with investment opportunities in global bonds where you can now actually get, you can get back up to very attractive yields, you know, 6% type yields, in portfolios of really quite high quality global bonds, and that cash isn't as attractive anymore with yields coming down.

PEDER BECK-FRIIS: Yeah. And without taking much credit risk. So very attractive. 

RUPERT HARRISON: Yeah, exactly. 

PEDER BECK-FRIIS: But look, you know, we touched a bit on fiscal policy, clearly the outlook for gilts very much depends on fiscal policy, we have big important budget coming up, important for the government, potentially important for financial markets. So, you know, why don't you lay out our sort of baseline view, what we expect now for the budget, you know, in terms of taxes spending and what that may mean for the fiscal deficit going forward.

RUPERT HARRISON: Sure. Well, we're back to the kind of annual or six monthly cycle of a massive amount of speculation building up to this budget. And I, but I think we all know the reasons for that, which is fundamentally, the chancellor has given herself quite a small amount of headroom against her fiscal targets.

And we, I think, believe very strongly that the treasury and number 10 value those fiscal rules. They're not going to abandon those fiscal rules because of all the, you know, the history. But it's a bit like, you know, if you set out on a hundred-mile journey and within a, with 105 miles’ worth of fuel in the tank, you're taking quite a few risks. And that was a decision that she chose to take in her first budget and then again in the spring statement. 

And so as a result, she's now facing, I think, you know, widely expected and indeed the treasury are effectively briefing the media that this is going to happen. Quite a big downgrade in her forecast, but a downgrade that in any normal circumstances would probably be something that she might be able to absorb. But because she's chosen quite a small amount of headroom, if she wants to carry on hitting her fiscal targets, she's going to have to raise tax.

And the question is just how much, so she's facing a whole, partly because some of the welfare reforms and savings that were previously planned by the budget, by the government obviously fell through in the House of Commons. They didn't get those through. So that's welfare reform. Also the winter fuel payment, add that together, that's maybe six, 7 billion or so.

That she's also facing and I think, again, this has been effectively confirmed by the treasury to the media that they're expecting a downgrade from the office of budget responsibility to their crucial assumption about future growth. And that is that trend productivity growth in the UK has been disappointing recently. And they think that some of that is going to continue and so they're going to reduce their assumption for future growth by maybe 0.2, 0.3. 

PEDER BECK-FRIIS: And can I just chime in there? Why, why does that matter for fiscal policy of future growth as well?

RUPERT HARRISON: So it matters because more growth means more tax revenues fundamentally. And so, if you're really going to have less growth, less wage growth, particularly 'cause wages are very tax rich, as people earn more, they pay more tax. If you're going to have less growth, you're going to have less revenues. And therefore to sustain the level of spending that's been planned on public services and welfare, you're going to have to raise more tax.

So the numbers that are floating around, you know, are, I think you always have to be a little bit wary at this stage ahead of a budget, because some of this is expectations management by the treasury. They want to get the bad news out first. So it may be on the day it doesn't seem quite as bad, but the numbers are somewhere between 20 billion and 40 billion, and I think that where it is in that range is really going to crucially determine the decisions that Rachel Reeve's going to take. 

I think we can assume that spending reductions are going to play a small part in this, if at all, and maybe a little bit, but the government seems to run out of road on for the time being on cutting welfare spending, and she only just set out spending plans in the spending review. So it would be quite difficult for her to come back and cut those. So it seems to be on tax.

The issue is, of course, the Labor Party went into the last election pledging not to raise the main rates of income tax national insurance on employees. It turned out and value added tax. And the problem is that at the upper end of that range of how big the gap could be, if it's 30 to 40 billion, it's very hard to plug that gap without going for one of the big leavers. 

And certainly if you look historically at chancellors that have raised significant amounts of money through tax rises, so I think about Gordon Brown in 2021, sorry, in 2001, with the national insurance rise to pay for the NHS. That was, again, big simple lever brings in a lot of tax. George Osborne after 2010, as part of the deficit reduction plan, raised VAT by two and a half points that raised more than 10 billion.

Again, it's a really reliable lever. It brings in the money. I think that the big decision is are they going to have to break the manifesto commitments or the, is she going to go for income tax? And I think most economists, and I think most market observers would say that's going to be better for the economy. It's less distortionary than some of the alternatives. You come out with a long list of taxes on capital property, and wealth you might get some money in. 

But A, that's going to be more unpredictable because you get some strange behavioral responses sometimes to those taxes. And also it's likely to have more of a distortionary effect on the economy, whereas an income tax rise, you know, a tax rise is never great, but it's relatively simple, doesn't have such a big distortionary effect on the economy.

So, I think that that is the big judgment, and I think that probably that decision still hasn't been made, because the numbers are still moving around. And for a politician to really go out there and say, look, I know I made a promise, but the world has changed and I'm going to have to break that promise. While in many ways that might be, you know, economically preferable. It's a very difficult thing to do politically. 

PEDER BECK-FRIIS: So, if you go back three years ago under Liz Truss and lots of market volatility after that event, we saw a little bit of market volatility last year in the autumn budget. So obviously we tend to focus at PIMCO, we speak a lot about baselines, but I think most of our discussions tend to be on the risk cases.

You know, what could be on the upside and downside and in particular from a financial market point of view, you know, what could cause, you know, a big decrease in interest rates, what could cause a big, you know, market reaction to the upside on interest rates. 

RUPERT HARRISON: So I think that there are probably three risks that are there in the budget. And I guess, I would say two of them are probably less likely, I hope they're less likely. And then the third one that we are going to have very close eye on. The first risk is a loss of fiscal credibility and I think that would come if Rachel Reeve said, actually, this is all too hard.

We're going to water down our fiscal rules, we're going to borrow more. I think that, you know, there've clearly been elements within, but actually on both sides of the political spectrum in recent years saying, oh, we should be more relaxed about the deficit and it hasn't gone well. And I think that that is very unlikely.

I think that certainly this Chancellor, this Prime Minister, they've states their political message and their reputations on economic stability, that they're deliberately trying to contrast themselves with the experience under the previous government and the trust many budget. 

And so I think that in our view, they do understand the importance of the fiscal rules and they'll do what it takes to meet them. So that is a risk, and clearly we need to keep an eye on that, but I think it's less likely the second risk comes back to the inflation story you were telling where UK inflation may be coming down, but it's been frustratingly sticky and that has fed into higher gilt yields, which then harms the public finances. And so anything that the government does that raises inflation and makes the Bank of England's job harder is going to create risks for markets.

PEDER BECK-FRIIS: And what would be an example of that?

RUPERT HARRISON: So an example of that would be an indirect tax rise. So, increasing VAT or increasing fuel duties or duties on alcohol and tobacco. It would also be a, you know, another tax rise that was a big cost increase for business, like the employer national insurance rise. We know that those tend to get passed on in the end, partly in higher prices, as well as maybe lower employment. And so I think that, again, that would be a risk.

Again, this is a risk that I think the treasury now very well understand. I think there's been briefing actually, you know, to the media of the opposite. I think there might be a kind of mini rabbit of the hat on the day where they try and say, actually we're doing some things to reduce inflation. So there've been, you know, suggestions. They might cut VAT on domestic fuel, for example. 

PEDER BECK-FRIIS: And then logic B, then the inflation would fall, and that would allow…

RUPERT HARRISON: Inflation falls; interest rates can come down faster. 

PEDER BECK-FRIIS: And that may even have a fiscal benefit.

RUPERT HARRISON: And then it has maybe a knock through into the fiscal arithmetic because less debt interest means maybe you need to borrow a bit less. So the inflation risk, I think, again, more unlikely. I think that the third risk is kind of implementation risk that they set out to deliver something that looks credible that meets the fiscal rules, but actually sort of falls apart under scrutiny or market participants take a look at it and say, actually we just don't believe this tax rise is going to happen.

Or if it does happen, we think the behavioral response will be so big that actually the revenues won't come in. You know, there have been some tax changes over recent years that have had that characteristic. So there was, both governments have, both parties have, for example, changed the non-domicile tax regime and there were some quite big numbers penciled in for how much that would raise. 

And I think the jury's still out on whether that's actually going to happen, whether maybe actually the response in terms of people choosing to leave the country or take their investments elsewhere might undermine some of that revenue. So I think that we will be, you know, as investors looking for, you know, predictable, reliable tax rises that don't come with too much economic cost and that really just, you know, satisfy, tick the box on implementation. It's like, yes, you have to raise taxes, no one ever likes doing that, but you've done it.

We think it looks believable, it's put the issue to bed. And I think crucially also, you know, if you can increase the headroom, you know, like let's not be in this situation again in six months’ time. You know, maybe like put 120 miles of fuel in the tank rather than 105 miles. And just yeah, allow for a few more eventualities.

But I mean, I guess the question, bring that again, back to markets is if we do get these, this sort of delivery in the budget, if they raise taxes, put the fiscal concerns to bed, how does that feed back into the investment view? How does that feed into the path for interest rates? How does that feed into the view on gilts? 

PEDER BECK-FRIIS: Yeah. Well I think, the two main effects I think, first of all, you know, if the government follows through on the fiscal tightening, you know, the fiscal deficit now is around 5% say that they managed to cut that to perhaps two or 3% in future years, then I think markets will probably price in a little bit more fiscal credibility in the UK. So some of the risk premium that's priced into a lot of UK assets, may be sort of priced out, and that may lead to, you know, long end interest rates, long end gilt yields to fall a little bit.

But I think the most important point is just the effect on macro and activity and inflation. You know, if we are in for a potentially multi-year period of fiscal tightening in the UK, that traditionally is something that would, you know, weigh on activity, weigh on demand, growth would likely slow. And, you know, in most cases probably lead to lower inflation as well. And if you think of, sort of standard monetary policy mix, you have a tight fiscal policy. And just going back to what we spoke about earlier, the good news is we have a lot of monetary policy space. And I think that will add pressure on…  

RUPERT HARRISON: The governments may have run out of ammunition, but the central banks have it.

PEDER BECK-FRIIS: Exactly! And you know, I think there's, you know, clearly room for Bank of England to partially upset some of this fiscal tightening. So, you know, we spoke about, you know, sort a baseline view of 275 terminals, but if we see, you know, front loaded fiscal tightening, you know, big fiscal tightening next year, then I think there's certainly room for micro to cut. 

RUPERT HARRISON: Even to the downside.

PEDER BECK-FRIIS: You know, we might be in for a multiyear period of fiscal tightening in the UK and I think over time that may add pressure on the bank of being to cut even below, you know, the 275 number that we spoke about earlier.

RUPERT HARRISON: So, even below then I guess, if the government is having to weigh on growth because it's having to be tough on spending to the extent it can, it's having to raise taxes and therefore weigh on growth, maybe weigh on inflation, that gives the Bank of England even more flexibility. 

PEDER BECK-FRIIS: Yeah. And I think the key number clear of a Bank of England is inflation, you know, an inflation targeting Central Bank. But yes, I mean, if we were to see a lot of fiscal tightening, then I would expect that to lead to lower inflationary pressure at the time.  

RUPERT HARRISON: Yeah. So I guess, I mean that really does bring us full circle in a sense in that the UK is like, as a bit of a petri dish for what's going on in the world. We've got this sort difficult deflationary journey, which in the UK maybe has been put on pause, but we think will resume, meaning that Central Banks now are in a space where yeah, they can cut rates and maybe that rate cutting cycle, which is happening in America has basically already finished in the Eurozone and is sort of temporarily on hold in the UK can resume.

It's a world where governments are much more constrained and maybe markets are gonna be looking at fiscal issues much more carefully. You know, we should note that yes, we like owning gilts, but we like owning them more in the sort of five to 10 year parts of the curve. 

We don't really think that we want to own gilt out of the 30 year point, which is the part  of the curve that is much more sensitive to those fiscal fears and fears about fiscal credibility. And again, that's the theme that has been playing out across markets globally. And all that comes together with falling interest rates on cash to make a case for, actually this could be quite an exciting time to invest in global bonds.

That's 'cause gilts have been outperforming, but actually if you look across our global portfolios, there's a really exciting case that you can get a good starting yield and because it's now the Central Banks that have all the ammunition if things go wrong.

So if you have a recession, which actually is not our base case for any economy at the moment, but a slow down or something goes wrong, the Central Banks have got that ammunition to cut rates and then you get that extra capital kicker from your bonds because interest rates are being cut and maybe the, you know, all of that maybe might be coming down the track in the UK over the next six months or so. 

PEDER BECK-FRIIS: Absolutely! Very good summary!

RUPERT HARRISON: Okay Peder, thanks for a great discussion and thanks to all of you for joining us!

Thanks for tuning in to Fixing Your Interest. Today’s conversation unpacked how UK fiscal constraints, sticky inflation, and monetary policy are shaping market dynamics. Rupert and Peder explored why gilts remain attractive, especially in the five-year part of the curve, and how upcoming budget decisions could influence growth, inflation, and interest rates. Strategic positioning and fiscal credibility emerged as key themes for UK investors. For more insights on navigating volatility, inflation, and the evolving macro-outlook for UK investors., visit PIMCO.com and subscribe for future episodes