Like an XL Bully on fireworks night, the bond market is heavily muscled, jumpy and looks ready to kick off. The government borrows money from the market by selling bonds, known as gilts, and the yields (the borrowing cost) on gilts have been climbing in anticipation of Rachel Reeves’ upcoming Budget (30 October). The “spread” between the yields on German and British government bonds is at its highest point for over a year, and some analysts are concerned that if the Chancellor announces a large increase in borrowing, she could incur the market’s wrath.
The yield on ten-year UK gilts is currently higher than they were in the weeks before the Mini-Budget presented by Kwasi Kwarteng in September 2022, in which a package of tax cuts funded by £70bn in new borrowing (in a single year) prompted a bond market sell-off that strained the wider financial system to the point of disaster, until the Bank of England stepped in with the soothing opiate of quantitative easing.
Two years later, Rachel Reeves is expected to announce changes to the fiscal rules that could allow for up to £60bn in extra borrowing to fund investment. On Wednesday the chief UK economist at Citi, Ben Nabarro, warned that tens of billions of new debt issuance could lead to a “buyers’ strike” – a collapse in prices that could have similarly messy results.
Will Reeves face her own Truss moment? If you’re in a hurry: no. If you’re in less of a hurry: the rise in yields in recent weeks isn’t exceptional – they are no currently no higher than they were in July of this year – and it’s probably explained by something else.
Dominic White, chief economist at the economic research provider Absolute Strategy and a former economic advisor to the Treasury, says the current rise in bond yields is “mostly a repricing of what investors think the Bank of England is going to do over the next year or so”; the UK’s economic growth has exceeded most investors’ expectations, which means the market generally thinks the Bank will now cut rates more slowly to keep inflation in check.
Similarly, the growing spread between German and British bonds doesn’t reflect a fear among investors that our Chancellor is about to splurge, but a prediction that Germany’s faltering economy will need more help: “there’s a view that the ECB will cut rates faster. That’s really been the main thing driving that widening of gilts versus German bond spreads.”
The American political strategist James Carville famously said he wanted to be reincarnated as the bond market – “you can intimidate everybody” – but the truth is more prosaic. “The majority of bond yields are driven by what investors think is going to happen to short-term interest rates”, says White. Liz Truss may have imagined woke bond traders conspiring to oppose her tax cuts, but in reality they just predicted that the cuts would be inflationary, and that the Bank would have to keep rates higher for longer.
Reeves is preparing to do something very different – borrowing to invest, rather than borrowing for tax cuts – and this is a very different time: inflation has come down, the labour market isn’t as tight. A look at recent gilt auctions shows demand for UK government debt is very strong, and Reeves is approaching her Budget with extreme caution. (Truss, lest we forget, never met the Governor of the Bank of England while she was prime minister.) We can’t entirely rule out a market reaction to the Budget, but Reeves must be realistic about its dangers; investors should not be the final arbiters of fiscal policy.
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