Our 2023 outlook for the UK and for gilts

Driven by recession on the one hand and higher policy rates on the other, gilt yields could be range bound next year.

The UK economy is facing a range of challenges, from structural issues (the most obvious of which is Brexit) to the energy crisis. Prime minister Rishi Sunak faces a difficult task in trying to rebuild confidence. In particular, he has to restore trust in the outlook for UK public finances without asphyxiating the UK’s already weak economy through an excessive tax burden. We forecast UK GDP to decline by 1.6% next year and consumer price inflation to average 6%.

After hiking by 50bp to 3.5% at its December meeting, we expect the Bank of England to implement two more 50bp hikes before a final 25bp rate increase to 4.75% in May. But this could depend on the severity of the recession in the first half of the year and whether the Federal Reserve hikes again in March. As of 19 December, market participants were pricing in a bank rate of 4.63% by June. 

Even though in October many market participants (us included) feared that the UK government bond market rout was taking on an emerging-market flavour, the fall in yields and sterling’s strengthening against the US dollar since then lead us to believe that the new government has already regained some of the credibility the UK lost around the time of the mini-budget in late September last. But the Bank of England’s resolve in its fight against inflation will also be crucial in avoiding another sharp rise in long-term gilt yields.

Even though in October many market participants saw hints of an emerging-market crisis in the UK government bond market rout, the fall in yields and sterling’s strengthening against the US dollar since then shows the new government has regained some of the UK’s lost credibility. Nevertheless, the Bank of England’s resolve in its fight against inflation will also be also crucial in avoiding another sharp rise in long-term gilt yields.

We expect UK gilt yields to remain range bound between 3% and 3.8% next year, driven by still-elevated inflation and higher policy rates on the one hand and falling economic growth on the other. Forecasting the 10-year yield to end 2023 at 3.3%, we have recently moved from an underweight to neutral position on UK gilts.

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