By Yoruk Bahceli, Amanda Cooper and Harry Robertson
LONDON (Reuters) -Shorter-term British government borrowing costs headed for their biggest weekly jump in over a year on Friday, while the pound was set for its biggest weekly loss against the euro in three months as Labour's tax-and-spend budget raised inflation expectations.
Two-year gilt yields, which led the selloff as investors pared back rate cut expectations, have risen 26 basis points on the week, set for their biggest weekly increase since June 2023.
Benchmark 10-year yields were up 21 bps, the biggest weekly move this year, having touched their highest in a year on Thursday at 4.526%.
But they dropped on Friday and sterling rose, suggesting investor sentiment was calming, also helped by weak U.S. jobs data.
While the surge in government borrowing costs and the drop in the pound are sizable, the speed and scale are far short of the crisis that rocked markets in September 2022 following then-Prime Minister Liz Truss's budget of billions in unfunded tax cuts.
"2022 was something really quite off the scale. But that doesn’t mean that what we saw this week wasn’t important," City Index market strategist Fiona Cincotta said.
Yields have jumped as markets digest the government's plans, which will add nearly 70 billion pounds a year to the public spending bill, according to Britain's fiscal watchdog, with just over half covered by higher taxes and the rest by increased borrowing.
The UK's Office for Budget Responsibility now expects inflation will average 2.6% next year, compared with a previous 1.5% forecast.
Traders expect around 90 bps of rate cuts by the end of next year, having priced in well over a percentage point prior to the budget.
They still expect a rate cut at the Bank of England's meeting next Thursday but have reduced the chance of a December cut to less than 50%.
Some investors said the moves may be exacerbated by positioning shifts, with many investors having favoured gilts before the budget.
BNP Paribas (OTC:BNPQY) Asset Management told Reuters it had closed its overweight position in gilts, while Artemis is selling 10-year gilts following the budget.
BUYING OPPORTUNITY
Investors including Vanguard, Lazard (NYSE:LAZ) Asset Management and AXA Investment Managers reckon gilts look attractive with higher yields.
"It doesn't strike us as an irresponsible budget," said AXA's head of total return and fixed income Nick Hayes.
"When I speak to the investment banks, they talk about decent buyers of gilts across the curve... you're not seeing any panic selling."
Rabobank said on Friday the market reaction had been "overdone," with the OBR expecting Britain's deficit, based on current spending and revenue, to turn to a surplus in four years.
Sterling edged up 0.8% against the euro on Friday, though it was still headed for its biggest one-week slide against the single European currency since late July, down 0.5%.
Against the dollar, it was up 0.5% on the day at $1.2962, flat on the week, after four straight weeks of declines.
The currency not rallying as markets reduce rate cut bets shows the budget is not being seen as good for growth, City Index's Cincotta said.
The OBR revised up growth projections modestly for this year and next, but lowered them for 2026-2027.
Investors are sitting on one of the largest bullish positions in sterling on record., worth $6.05 billion and the biggest bet against the dollar among the major currencies, according to the most recent weekly data from the U.S. markets regulator, making it vulnerable to further drops.
The derivatives market shows traders are more willing to pay more for options to sell sterling rather than buy it than at any time in the last 16 months.
"We like short GBP even more given its limited move so far," Neil Mehta, portfolio manager at BlueBay Asset Management, said.
For the time being, UK bonds were likely to remain jittery, with the U.S. presidential election taking place next week.
"We anticipate high volatility in global rates markets next week, which could be even more pronounced in gilts," Lazard Asset Management's co-head of global fixed income Michael Weidner said.