Public sector borrowing is coming in close to the Office for Budget Responsibility’s (OBR) November 2023 Autumn Statement projections. The Central Government Net Cash Requirement (CGNCR) – the amount of money the government needs to borrow every year and which forms the basis of gilt issuance – stands at £121.9bn in the 10 months to January. This is broadly consistent with the OBR’s forecast of £150.5bn for the full 12 months of 2023-24.

When it comes to public sector net borrowing, we forecast a deficit of £114bn – equivalent to 4.2% of GDP – in fiscal year 2023-24, which is £10bn below the OBR’s November 2023 forecasts. Cumulative interest payments for the 10 months to January 2024 are down by £28.9bn from the same period a year ago – a drop of 29.5% – while spending by government departments has continued to moderate. 

Public expenditure & tax receipts, % of GDP (TME = Total Managed Expenditure)

For reference, the 2023 Autumn Statement brought about some modest fiscal policy easing, amounting to £6.7bn (0.2% of GDP) in the current financial year and £14.3bn (0.5% of GDP) in 2024-25.

Reports suggest that the OBR has told the Chancellor he has headroom of about £12bn, which would permit a 1p cut to the basic rate of income tax (estimated to cost around £6bn in FY 2024-25) or the main rate of employee National Insurance Contributions (around £4.6bn). A 2p cut would require some spending cuts or other taxes being raised. In short, the scope for fiscal policy easing looks limited.

Cuts to headline tax rates seems far more likely than altering tax thresholds or allowances, which would be expensive in terms of lost revenue, and arguably less visible to voters. The recent combination of high nominal wage and price inflation coupled with frozen allowances has resulted in a surge in tax revenues and contributed to tax receipts as a percentage of GDP climbing to multi-decade highs.

The fiscal challenges facing the UK in the medium term are sobering. Achieving the main fiscal rule that public sector debt as a percentage of GDP should be falling by the fifth year of the current forecast (made in November 2023) will require a significant and sustained reduction in public spending as a share of GDP, with total managed expenditure down from 45.1% of GDP in 2022-23 to 42.7% by 2028-29. 

Public sector net debt, % of GDP

Even though there have been large-scale cuts to public spending before – it fell by 7% between 2009-10 and 2018-19 – implementing such cuts will be challenging from a political perspective.

We expect £258bn of gross gilt issuance in the 2024-25 fiscal year, an increase of around 9% from 2023-24, although this will in large part be driven by higher redemption in the upcoming fiscal year (£140bn compared with £117bn). Net issuance is set to fall very marginally, but that won’t change the bigger picture: we’re still in a period of sustained, high gilt issuance.

We expect continued high gilt issuance to weigh on yields, such that they won’t be pulled down as much as might be expected in a rate-cutting cycle. Our long-term fair value for 10-year gilt yields is 4%, but we expect them to remain above this level in the near term.

The heavy supply outlook is likely to weigh more heavily on gilts than other markets for four reasons, in our view. 

• The change in net supply relative to the size of the market is much larger than in other regions. In the US, for example, supply net of quantitative easing and quantitative tightening will be double the pre-covid average in 2024. In the UK, it will be at least four times bigger. 
• This is partly because quantitative tightening is happening faster (relative to the size of the balance sheet) in the UK. 
• The UK Treasury is on the hook for any losses that the Bank of England incurs by selling its bond holdings, and such losses immediately add to financing needs.
• Finally, the UK has experienced a bigger structural shift in demand at the long end of the curve than other markets. Domestic pension funds could in the past be relied on to absorb a significant amount of duration, but this demand no longer exists to the same extent.

The Debt Management Office (DMO) will probably respond by skewing issuance towards short duration bonds, but we think the market has already priced this in. 

Although we entered the year concerned about how the heavy supply outlook might weigh on yields, global supply has been much better absorbed so far in 2024 than we expected. Markets should not be complacent, though. There’s still plenty of supply to come throughout the year, and the further that monetary easing gets pushed into the future, there will be less immediate demand for fixed income. 

The UK could suffer particularly badly given that we expect the Bank of England to keep rates higher than other central banks. A Budget that brings about some degree of fiscal easing is unlikely to help from that perspective.

NatWest interest rate forecasts, %

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