UK bonds slide after inflationary UK budget hurts BoE rate cut bets
Markets reduce expectations for BoE rate cuts after budget
Fiscal watchdog sees inflation averaging 2.6% next year
Ten-year gilt yields rise to highest in a year
Investors still expect BoE to cut rates next week
Recasts throughout with latest market moves and new analyst comments, adds Starmer's spokesperson, paragraphs 17-18
By Andy Bruce and David Milliken
LONDON, Oct 31 (Reuters) -British government bond prices tumbled for a second day on Thursday as investors judged finance minister Rachel Reeves' first budget would boost inflation and cause the Bank of England to cut interest rates more slowly.
Reeves announced the biggest tax rises in three decades, saying she needed to repair the public services, alongside a big rise in borrowing to fund investment on Wednesday.
Britain's budget watchdog said her plans would boost economic growth in the short run, but it expected inflation would average 2.6% next year compared with a previous 1.5% forecast.
That prompted investors to reel in bets that the BoE would reduce interest rates rapidly over the next year.
Two-year gilt yields GB2YT=RR jumped by as much as 22 basis points to 4.539%, heading for the biggest one-day rise since August 2023 although by the close they were only up 11 bps on the day - still the biggest daily rise in four weeks.
Ten-year gilt yields GB10YT=RR hit a one-year high of 4.526% and finished the day around 10 bps higher at 4.45%.
The yield premium of 10-year gilts over 10-year German Bunds rose above 208 basis points and closed at its highest since October 2022 when markets were still in turmoil after Liz Truss' "mini-budget".
The pound also fell on Thursday, set for its worst two-day loss against the euro in two years.
"The quiet optimism that appeared to be spreading during Rachel Reeves' speech has evaporated and a higher risk premium has returned for UK debt," said Susannah Streeter, head of money and markets at brokers Hargreaves Lansdown.
Cedric Scholtes, head of global sovereigns, inflation and rates at BNP Paribas Asset Management, said he was no longer overweight on gilts.
"We were wrong on the budget," he said, adding overall borrowing was no surprise but the front-loaded increase in spending, a higher minimum wage and greater employment costs for employers would boost inflation.
Compared with Truss' announcement of debt-funded tax cuts and spending - which ultimately led to her resignation - the fall in gilt prices this week has been smaller and focused on shorter-dated gilts.
Thirty-year gilt yields GB30YT=RR rose by 5 basis points on Thursday but, much less than the 50-basis-point rise on the day after Truss' "mini budget".
Reeves' changes to fiscal targets also got some support from the International Monetary Fund, unlike its criticism of the approach taken by Truss.
FEWER RATE CUTS EXPECTED
The focus on two-year gilts suggested the move was motivated by reduced expectations for BoE interest rates, rather than longer-term concerns about the health of the public finances.
J.P. Morgan economist Allan Monks said higher demand and inflation over the next two years would "make it harder for the Bank to deviate from its gradualist mantra on rates".
Asked to comment on the fall in bond prices, the spokesperson for Prime Minister Keir Starmer said: "We don't comment on market movements."
"The chancellor (Reeves) has been very clear that first and foremost, this budget has been about restoring fiscal stability, and she's outlined two new robust fiscal rules, which put public finances on a sustainable path," the spokesperson said.
Investors still think the BoE is likely to cut rates next Thursday by a quarter of a percentage point. Rate futures were pricing that as a nearly 80% probability on Thursday, down from 95% before the budget.
But Reeves' plans sowed greater doubt about the outlook for rate cuts further ahead with investors pricing in around 0.85 percentage points of BoE rate cuts between now and the end of 2025, down from 1.2 percentage points just before the budget.
By comparison, they were still pricing almost five further quarter-point cuts from the U.S. Federal Reserve and European Central Bank - both of which have already cut borrowing costs more than the BoE.
Some investors think the negative bond market reaction to the budget will prove short-lived.
"We continue to like gilts," said PIMCO economist Peder Beck-Friis. "Over time, we expect the market to price in a lower terminal rate for the Bank of England's cutting cycle."
But others expected the BoE Monetary Policy Committee to block next week's expected rate cut.
"We reckon the sell-off in gilts has further to go," said Laurence Mutkin, head of EMEA rates strategy at BMO.
Additional reporting by Harry Robertson; Editing by Jamie Freed, William Maclean and Alison Williams
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