Rachel Reeves has a bond market headache. After a rise in the government’s borrowing costs, with the 10-year cost of debt hitting the highest level since 2008, the chancellor is in danger of breaking her fiscal rules.
For the past 15 years, western governments have been able to rely on the financial markets for cheap borrowing. After the 2008 financial crisis the world’s most powerful central banks cut interest rates close to zero, while inflation remained low, with the idea to help reboot economic activity.
In the years since the peak of the Covid pandemic those trends are now firmly in reverse with serious consequences for governments worldwide. Here we explain how the bond market is rattling the chancellor.
Why are bond yields rising?
Government borrowing costs have risen worldwide as investors weigh up the prospects of stubbornly high inflation forcing central banks to hold back from cutting interest rates by as much as previously hoped.
Inflation skyrocketed after the exit from Covid lockdowns and the energy shock triggered by Russia’s war in Ukraine, leading central banks to drive up interest rates in an attempt to bring it back to target.
Inflation has cooled over the past year, leading central banks to cut rates. But inflationary pressures have appeared more persistent than previously hoped in recent months – limiting the scope for further cuts.
Is Britain alone?
Part of the problem in the UK is domestic: the resilience of wage growth, service sector prices, and fears the new Labour government’s tax and spending measures could stoke inflation.
However, there is also a global dimension: investors fear Donald Trump’s tariff proposals could also fuel inflation, forcing the US Federal Reserve to keep interest rates higher for longer. Trump’s tax-cutting plans could also drive up the national debt, adding to the supply of US Treasury bonds.
City analysts point to rising borrowing costs across developed markets. “People often think of the UK as being a market that behaves somewhere in the middle of the US and the eurozone,” said Mark Capleton, an analyst at Bank of America.
“For 10-year yields over the past three months, the US is up 65 basis points, the UK up 46 basis points and Germany is up 22 basis points. So the UK is somewhere in the middle.”
Is this Liz Truss 2.0?
Some investors are warning the government has added to its bond market woes.
Economic growth has flatlined since Labour came to power in July, in part due to depressed consumer and business confidence after Reeves warned that large tax rises were needed to fix the dire inheritance left by the Conservatives.
Investors also fear her autumn budget could add to inflationary pressures; particularly the increase in employer national insurance contributions, which is projected to raise £25bn in this parliament, and the rise in the minimum wage from April.
The Treasury is preparing to sell about £300bn of bonds this year to refinance maturing debts and to cover the annual budget deficit – a historically substantial sum. The Bank of England is also adding about £100bn more to the supply of gilts as it winds down its quantitative easing scheme. This reverses its position of recent years, when it had been among the largest buyers.
Yields have risen above the peak seen after Liz Truss’s 2022 mini-budget. Still, the situation is markedly different.
Back then, the UK stood out on the international stage for both the speed of the increase in borrowing costs and the peak they reached – leading some analysts to talk of a “moron premium” for Britain.
Truss’s mini-budget triggered a rapid shift in markets, rattling the pensions industry and forcing the Bank of England to intervene. However, the recent increase has taken place over a longer timeframe, which is more manageable for investors to adapt to.
Why does this cause a problem for government finances?
A sustained rise in borrowing costs could wipe out Reeves’s headroom against her fiscal rules when she presents her “spring forecast” on 26 March.
At the autumn budget, the Office for Budget Responsibility forecast that the chancellor’s main rule to balance day-to-day spending with tax receipts by 2029-30 would be met with £9.9bn to spare.
With a national debt totalling £2.6tn, almost equal to the annual output of the economy, the OBR reckoned the government would need to spend about £104.9bn to service its debts in the current financial year – a sum worth more than the annual education budget – rising to £122.2bn by the end of the decade.
However, weaker growth, stickier inflation, a higher Bank rate and higher long-term borrowing costs than expected in October could lead the Treasury watchdog to revise up its forecasts for debt servicing costs when it presents its March update.
Economists reckon the OBR could scrub out all of the £9.9bn headroom Reeves has in reserve.
What are the chancellor’s options?
Reeves’s 26 March spring forecast had been expected not to include any tax and spending changes, with the chancellor preferring one big fiscal event a year to give families and businesses more stability.
However, she would be unlikely to allow a damning OBR verdict without any corrective action.
Reeves has though created something of a triple lock for herself; with a primary commitment not to break her fiscal rules, but also not to further increase taxes, and to meet Labour’s pledge of no return to austerity.
“The risk is, having been seen to have U-turned on tax between the July election and the October budget, Chancellor Reeves faces a credibility problem with financial markets,” said Simon French, an economist at Panmure Liberum.
The Treasury has insisted the fiscal rules are non-negotiable, signalling that any adjustments would come through spending cuts. This could pave the way for fresh measures in March and a tight spending review expected before June, but it would also cause fresh headaches for Labour; having been elected on a promise to fix battered public services and drive up living standards.
Reeves could, though, still catch a lucky break.
Some City analysts reckon financial markets have overreacted to the challenging economic and fiscal outlook. The OBR has yet to capture the financial market data used in its forecasts and will do so closer to 26 March – leaving some time for conditions to subside.
Financial markets are pricing in two quarter-point interest rate cuts from the Bank of England this year. However, many analysts, including at Bank of America and Goldman Sachs, expect a weaker economic outlook could lead Threadneedle Street to cut borrowing costs four times in 2025.
“The market has taken out too many rate cuts we think,” said Capleton. “We do think the Bank will manage to achieve quarterly rate cuts of quarter percent a time. That will help the situation; we think gilts are somewhat oversold here.”