Analysis-Bond investors bet UK's Reeves will avoid testing markets at budget

By David Milliken and Yoruk Bahceli

LONDON (Reuters) - Britain's borrowing costs have risen before the new government's first budget, which could open the door to a big rise in debt sales - but investors are not betting on finance minister Rachel Reeves pushing her fiscal options to the limit.

Reeves, who has ruled out many tax rises but wants to improve public services and increase infrastructure investment, is eyeing a change to how the government defines public debt.

That could allow her to borrow more while keeping to the letter of a pre-election promise to lower debt as a share of national income.

At first glance, investors in British government bonds appear nervous ahead of the Oct. 30 announcement of the first tax and spend programme of a Labour government in 14 years.

Benchmark 10-year gilt yields on Monday hit their highest since just before the July 4 election, while 30-year yields - considered a proxy for long-term budget risks - last week traded at their largest premium to German bonds in two years.

"We have seen a material reduction in demand from international real money," Benjamin Nabarro, chief UK economist at U.S. bank Citi, said.

Bank of New York Mellon said its clients sold 3 billion pounds ($3.9 billion) of gilts last month, the most since former Prime Minister Liz Truss' big unfunded tax-cut plans triggered a bond market crisis in 2022.

Economists say extensive changes to the debt rule could increase the room for borrowing by 50 billion pounds or more - a hefty sum compared with the 278 billion pounds of gilt issuance planned for this year and more than can be invested efficiently.

While investors and financial analysts see no chance of a repeat of Truss' mistakes and expect a limited rise in borrowing, some worry a more relaxed budget rule could blur the line between investment and day-to-day spending, which Reeves promises she will bring into balance.

"Until you see the proof of that you probably will stay out (of gilts) for a little while and see if she's going to be true to her word," said Simon French, chief economist at investment bank Panmure Liberum.

Others think gilts now look like a buying opportunity.

"We see new interest from investors to look at the UK market," said Cosimo Marasciulo, head of fixed income absolute return at Amundi, Europe's largest asset manager, noting that short-dated gilts seemed to offer best value.

HSBC described gilts as "cheap outright and cross-market" while Barclays told clients that "pessimism over the budget is too high and valuations look cheap".

According to the median forecast in a Reuters poll this month, 10-year gilt yields will fall to 3.85% by the end of 2024. Compared with their current level of 4.17%, that represents a bigger price gain than for either Treasuries or German bonds.

The upcoming budget has been far from the only thing affecting gilt prices.

Since late August, the spread that 10-year gilt yields pay over U.S. Treasuries has barely changed, but it has widened by nearly 0.25 percentage points over German bonds amid bets that the European Central Bank will cut rates quickly to help the euro zone's lacklustre economy.

Chris Jeffery, head of macro strategy at Legal & General Investment Management, said the weakness in gilts was due to Britain's slightly stickier inflation and stronger growth, delaying rate cuts.

"For me, the driver here hasn't really been the fiscal at all," he said. "The Bank of England is being less eager to embrace interest rate cuts than everyone else."

Markets are pricing 1.2 percentage points in BoE rate cuts by the end of 2025, less than the 1.5 percentage points expected from the Fed and the ECB.

MODEST CHANGES

Much of the optimism about gilts assumes that the borrowing implications of Reeves' budget rule changes are modest.

Goldman Sachs economists have predicted annual investment spending is likely to rise by 10 billion pounds if Reeves reverts to a debt definition used before 2022 that alters how losses by the Bank of England are booked.

A bigger change to target a fall in public sector net financial liabilities could prompt Reeves to spend 20 billion pounds a year more on investment, they said.

But both those estimates were well below the extra fiscal room for manoeuvre of 16 billion or 53 billion pounds that would be created by the two different changes in the rules.

Ben Zaranko, senior economist at the Institute for Fiscal Studies, cautioned that while measures of the public finances including assets might appeal to a government seeking to invest more, their inclusion of hard-to-value assets gave a less convincing picture of government solvency to investors.

"You can't sell off a school in a financing crisis. Some people argue you should put natural assets in there too. I love bumblebees as much as the next person but you can't sell off a bumblebee," he said.

($1 = 0.7637 pounds)

(Reporting by David Milliken and Yoruk Bahceli; Editing by Hugh Lawson)