LONDON Gilt prices leapt and benchmark yields fell to trade 9 basis points below Germany's on Tuesday, a 2-1/2 year low, despite widespread expectations that Britain will announce significantly higher borrowing needs for the coming years.
Chancellor George Osborne is expected to say in his autumn budget statement to parliament that he will have to borrow tens of billion pounds more than he expected eight months ago due to worsening UK growth prospects.
But analysts expect Osborne to stick with his commitment to deep spending cuts and, along with expectations that the Bank of England will expand its quantitative easing programme next year, this should reassure investors even if Britain has to increase gilt issuance this year.
BNP Paribas strategist Shahid Ladha said worries about the euro zone debt crisis and expectations of more BoE gilt buying were likely to maintain support for UK government debt.
"Net supply dynamics remain very negative into February at least and most of the Street, including us, expect the Bank of England to increase QE," he said. "The squeeze on gilts is likely to stay. It's been benefiting over November from outflows from Europe and concerns over European assets. That is benefiting safe havens like Scandinavia and UK gilts."
At 11:41 a.m., the March gilt future was 45 ticks higher on the day at 114.32, while the equivalent Bund was down two ticks.
In the cash market, the yield on 10-year gilts fell 8 basis points to 2.22 percent, around 9 basis points lower than that of the equivalent Bund, and the biggest premium over Bunds since early 2009 - implying that investors see gilts as a safer bet than their euro zone counterparts.
German Bund futures reversed early gains and European stocks .FTEU3 rose after Italy managed to sell debt in volumes close to the upper end of its target range, albeit with borrowing costs at a euro-lifetime high of nearly 8 percent.
Bank policymakers gave a gloomy assessment of Britain's economic prospects late on Monday, signalling they are prepared to expand their asset programme beyond the 75 billion cash boost they announced in October.
Barclays Capital strategist Moyeen Islam said an expansion of the scheme when the current programme ends in February would more than offset any additional gilt issuance announced today.
Analysts in a Reuters poll reckon the Debt Management Office (DMO) will revise up its gilt issuance plans by at least 3 billion pounds in the current 2011/12 fiscal year, with some strategists expecting an even bigger boost.
"The BoE as good as told us we'll likely see more QE, so it sounds as if there's at least another 75 billion pounds to come," Islam said. "So it is hard to be that negative for gilts going forward, because the Bank's buying will outweigh any extra issuance the DMO will do."
(Additional reporting by Peter Griffiths; Editing by Stephen Nisbet)