Sterling dips, gilt yields at 2-month high as investors assess Burnham's spending plans

By Stefano Rebaudo and Yoruk Bahceli

July 21 (Reuters) - Sterling dipped while UK gilt yields reached fresh two-month highs on Tuesday as investors weighed the prospect of higher government spending and how new finance minister John Healey will finance it.

The pound trimmed early gains against the dollar and was last trading down 0.37% at $1.3370. It fell 0.33% against the euro, which traded at around 85.27 pence.

The appointment of Healey, a former defence secretary, was announced after the close of UK markets on Monday. He had not been seen as a leading candidate for the key role in new Prime Minister Andy Burnham's cabinet, but his appointment was generally seen as positive.

However, he will have to find more money to invest in key areas while reducing the welfare bill, all while fulfilling Burnham's pledge to stick within the fiscal rules.

"Out of the choices he (Burnham) had, he (Healey) has some experience in Treasury, so I think that's a big positive," David Zahn, head of European fixed income at Franklin Templeton, said, adding Healey is not a far-left leaning member of the Labour Party.

"But I still think that the vision is Burnham's, and so he will have to figure out how to deliver the cash, which I don't think will be easy because they do want to spend a lot," he added.

British government bonds, known as gilts, were up with the 10-year bond yield a whisker higher at 5.0586%, its highest since May 20, up 2 basis points.

Gilts outperformed German Bunds after underperforming them on Monday as Burnham replaced Keir Starmer as prime minister. His early remarks that he would use any flexibility within the government's fiscal rules, reignited concerns about a possible loosening of fiscal policy.

Yields on 30-year bonds reached a fresh 2-month high at 5.7744%, up 2.5 bps.

DEFENCE STOCKS RISE

One area of spending in particular focus is defence. Healey resigned in June from Starmer's government, saying the finance ministry had been "unwilling" to find the money to keep the country safe.

London-listed defence stocks rose as much as 2% on Tuesday on expectations that Healey could boost defence spending, before paring gains to trade up 0.25%.

"The ambition to lift UK growth towards 2.5% is understandable, but there is no obvious quick fix," Anthony Willis, economist at Columbia Threadneedle Investments, said.

"That task is complicated by competing demands from defence and welfare spending," he added.

Investors were also digesting the latest UK economic data, which analysts said was positive for the new finance minister as it suggested the Bank of England may have room to ease interest rates over the next year.

British annual wage growth held at 3.4% in the three months to May, matching economists' forecasts, while UK public borrowing declined to £16 billion ($21.5 billion) in June.

Also on Tuesday, the government announced it would cut taxes on electricity bills, as Burnham attempts to deliver on his promises to ease a cost-of-living crisis, which was seen by analysts as a modest giveaway. 

(Reporting by Stefano Rebaudo and Yoruk Bahceli; editing by Dhara Ranasinghe, Jan Harvey, Timothy Heritage and Susan Fenton)