Given the fall in wholesale energy prices year-to-date, markets are focusing on the implications for the cost of the Energy Price Guarantee (EPG) to the UK government – especially now that it has been extended to April 2024 – and how this will feed through into gilt issuance.

So, will lower energy prices bring the cost of the EPG in substantially under budget? Our view is that the price drops have probably come too late to have any impact on costings for fiscal year 2022-23. For the following year, however, there could be some changes to the EPG’s estimated cost. One reputable forecast suggests prices in the second half of 2023 will likely remain below the EPG level, and therefore will not cost the government any money from July.

But we need to keep things in perspective: this figure pales into insignificance when compared with overall expected gross gilt issuance of close to £300 billion. For this reason, we believe markets should not overestimate the potential effect of falling energy prices on gilt yields. 

That said, the government has not costed the extension of the support measures for businesses in the Autumn Budget beyond March 2023. The cost of any ongoing support would therefore add to projections of the deficit financing effort.

In Europe, the European Central Bank (ECB) has announced €150 billion of quantitative tightening, which we expect to mean €120 billion of extra supply of European government bonds. The programme may accelerate in the second half, particularly if markets can absorb them without too much volatility. The European Commission’s November assessment of national draft budgets shows that energy crisis support is expected to fall across the region in 2023 from 2022 levels. 

The cost of funding energy support measures may amount to €260 billion, which is equivalent to almost 20% of gross bond issuance this year. A halving in energy prices means support may cost less than half the budgeted amount. This could translate into a reduction of at least €130 billion (equivalent to 1% of the eurozone’s GDP) in European government bonds if current gas prices are sustained. While this is a large number, it’s not a game-changer. 

We forecast the total ‘supply shock’ – that is, the extra bond supply the market needs to absorb in 2023 compared with 2022 – to be between €500-600 billion, down from our €700 billion forecast in our previous update late last year. 

Our Bund yield target is still 2.75% by March-April, but the risks now look more balanced around it. Germany is likely to be the biggest winner in terms of reduced need for funding, issuing €75-80 billion less bunds this year than previously expected. 

In the UK, falling wholesale energy prices may be a bigger deal for sterling than gilts. They would have an immediate impact on the UK’s balance of payments and, in turn, sterling. In fact, they might have an even bigger impact on sterling than monetary policy does in the current environment. That’s because markets judge the valuation of the pound by considering how a large and persistent current account deficit is to be funded by net foreign capital flows, and at what exchange rate. 

On balance, we think the downside risks to sterling are exaggerated, and that the pound is likely to rise moderately against the US dollar over the next 12 months as the dollar slips back from its cyclical highs and the Fed becomes less hawkish. 

In terms of the short-term outlook for economic growth and government borrowing requirements, we don’t think continued falls in energy prices will have a major impact. However, they will flatten the distribution of risks around housing market weakness, growth and borrowing, which could drive a reassessment of the risk premium in the eyes of markets.

While the outlook for the UK economy is still relatively poor, we think pessimism about the UK’s growth outlook is overdone, and that improving sentiment as gas prices fall should support the pound. At the very least, the risk that growth is much weaker than expected seems to have abated. Recent trends point to a move higher for sterling against the euro.

In Europe, business sentiment surveys and data point to an imminent improvement in German economic activity, probably driven by lower gas prices and the support being provided to firms and businesses with their energy bills. This also reflects more favourable inflation dynamics, which could result in easier ECB policy from here. A more normal mix of demand and inflation is also likely to support the euro against the US dollar.

It’s still possible that the ECB may take advantage of reduced budget pressure to accelerate its quantitative tightening process or spend the money it has saved on energy support measures in other areas such as social projects or the energy transition.

It’s important to remember that these are still early days for lower energy prices, and that good fortune can turn quickly, especially if there is a prolonged cold snap. Governments won’t bank the mark-to-market on their energy subsidies for some time, and funding plans aren’t likely to change until they do. As such, lighter government bond supply might be for later this year. 

What’s more, there’s considerable uncertainty around all of these figures as we are not in a position to conduct a detailed bottom-up assessment of the impact of cheaper energy prices on support measures. 

To learn more about the potential impact of energy prices on your financial strategy, contact your NatWest representative or get in touch.