U.K. fiscal concerns remain elevated - BofA

Investing.com -- The United Kingdom (TADAWUL:4280) government is facing major fiscal challenges ahead of its June 11 Spending Review, which is expected to test its ability to adhere to a strict spending path in order to meet fiscal rules.

The high fiscal risks in the U.K. are due to increased spending pressures, rising yields, and the possibility of weak growth.

The Chancellor is expected to announce fiscal consolidation measures in the Autumn to meet the government’s fiscal rules.

This is due to the prospects of a dovish pivot by the Bank of England (BoE), the potential reduction of the BoE’s Quantitative Tightening (QT) envelope, or the shortening of the Debt Management Office’s (DMO) gilt issuance maturity.

These measures could help alleviate pressure on U.K. long-end yields.

However, the possibility of downgrades to medium-term growth due to weaker productivity, lower migration, and U.S. tariffs could significantly reduce the headroom, keeping fiscal consolidation risks alive.

The Spending Review will involve setting detailed budgets for individual departments for future years. Meeting the tight spending pathway could require harsh cuts for unprotected departments, given the increasing needs for health and defense spending.

After tough negotiations with individual departments to set budgets for the next few years, it may become more difficult for the Chancellor to announce spending cuts in the Autumn if forecasts move against her. This could increase the risk of tax rises to restore fiscal headroom.

The Spending Review will be critical for the government’s efforts to prop up market confidence, given its tight fiscal situation. The Office for Budget Responsibility (OBR) will not provide updated forecasts in June, so scrutiny on possible forecast changes will likely continue into the Autumn.

Bank of America (NYSE:BAC) (BofA) anticipates that the DMO will react to deviations from the OBR’s projections in a manner supportive of duration. An overshoot of the Central Government Net Cash Requirement (CGNCR) would likely be remedied as much as possible via additional net T-bill sales for debt financing purposes.

On the other hand, an undershoot is more likely to result in a reduction of the share of long-dated Gilt issuance. BofA also expects the DMO to continue with its shift to shorter-term borrowing in the meantime.

BofA has turned constructive on U.K. rates, currently favoring receiving longer-end U.K. real yields versus the US and long-end Gilts on Adjusted Swap (ASW).

However, concerns over fiscal sustainability present a significant risk to this more benign narrative.