If the Chancellor produces a credible fiscal package in the budget that involves a substantial reduction in the Public Sector Borrowing Requirement (the difference between government spending and government revenues), say from around £28bn in 1995/96 to £18bn in 1996/97, the gilt market is likely to react positively, for several reasons.
First, the PSBR has, ultimately, to be financed by the issue of government debt, which mainly means gilt-edged bonds. If the PSBR is lower, fewer gilts have to be issued. And if the supply of gilts is lower, other things being equal, then their price will be higher (and their yield lower).
Second, a cut in the PSBR of £10bn would be the equivalent of tightening fiscal policy by around 1.5% of the UK's GDP. This is bound to hold back economic growth, so increasing the likelihood of the Government achieving its target of getting underlying inflation below 2.5% by the end of the present parliament. Lower inflation should mean lower gilt yields.
Fourth, if fiscal policy is being tightened aggressively, it may be prudent for the Chancellor to sanction an early cut in base rates. Lower short-term interest rates, when judged prudent by the markets, are almost inevitably accompanied by lower bond yields.
When assessing how far yields might fall after the budget, the problem is judging how much good news is already in current market prices. We believe that, despite its strength in recent weeks, there is still some scope for the gilt market to be surprised by the Chancellor's determination to keep policy tight in the budget. Therefore, yields could fall again this week.