Divergence in Prospects for Interest Rate Cuts by the Bank of England and the European Central Bank, with the 10-year Yield Spread between UK and German Bonds Reaching a New High in Over a Year

Zhitong Finance learned that due to the sharp contrast in market expectations between the Bank of England and the European Central Bank's interest rate cuts, coupled with increasing concerns about the upcoming budget in the UK, the yield spread between UK bonds and German bonds has reached the highest level in over a year. The yield spread between 10-year UK government bonds and German government bonds has surged by 25 basis points in the past month, now approaching 2 percentage points, the last time it reached this level was in August 2023. The 10-year UK government bond yield is at 4.2%, near the highest level in three months.

German data shows a significant decline in private sector business activity last month, with inflation falling below 2%, leading traders to bet that the European Central Bank will continue to cut interest rates by 25 basis points next week, accelerating the pace of policy easing.

Meanwhile, it has been proven that the UK economy is stronger than expected, with the market anticipating a more gradual interest rate cut in the UK; higher UK yields also reflect increasing speculation that the UK government will need to issue more bonds to help fill the fiscal gap. UK Chancellor of the Exchequer Rishi Sunak is set to present a "make or break" budget on October 30.

SMBC Nikko Capital Markets' Senior Fixed Income Strategist Hank Calenti believes that the widening spread is mainly due to monetary policy outlook. Market pricing implies that by the end of 2025, the European Central Bank will cut interest rates by 150 basis points to 2%, while the Bank of England is expected to cut rates by 125 basis points to 3.75%. Calenti said, "This is a problem with many negative factors, and it seems a bit overdone. This is pricing in a recession."

In September, private sector business activity in the two largest economies in the Eurozone declined, with Germany's manufacturing sector worsening and France's service sector contracting. In contrast, the PMI index in the UK still indicates economic expansion. Benoit Anne, Managing Director of MFS Investment Management, said, "You can see this disconnect, which indicates that the German economy is really bad."

Furthermore, compared to US Treasury bonds, UK government bond yields have also risen. The yield spread between 10-year UK and US government bonds has widened to 20 basis points, nearing the highest level in a year. The Federal Reserve is expected to cut interest rates by about 150 basis points by the end of next year.

The rise in borrowing costs in the UK has made it more challenging for the Labour Party to achieve its goals of restoring public finances, encouraging growth, and investment. An internal analysis by the UK Treasury suggests that the government's plans to fund key spending through increased taxes could ultimately deplete Treasury funds.

Several economists suggest that Sunak should change her fiscal rules to allow more borrowing for investment to promote economic growth, rather than harming the economy with higher taxes. Elias Haddad, Senior Market Strategist at Brown Brothers Harriman, wrote in a report, "Investors are concerned that the UK Labour government will fund increased investment by issuing more bonds rather than raising taxes." ”