- Stocks and sterling seem content with the Labour government, bond vigilantes less so
- The yield on the benchmark 10-year gilt is higher than when Labour took office
- Chancellor Rachel Reeves has to balance the needs of backbenchers, voters and the markets
- Geopolitics has a role to play, too, with the defence budget set to rise
“Chancellor of the Exchequer Rachel Reeves will be approaching her second Budget with memories of the upset in financial markets caused by September 2022’s mini-Budget still fresh in her mind, but she also has to appease voters and consumers while sticking to manifesto promises on tax and international commitments to increase defence spending,” says AJ Bell investment director Russ Mould.
“Healthy gains in the FTSE 100 and the absence of tremors in sterling suggest that stock and currency markets are happy enough with their lot, and Labour’s influence over it. But an increase in the benchmark 10-year gilt, or government bond, yield means the chancellor will have to be careful when she delivers her speech and latest fiscal policy package on Wednesday.
“The 10-year gilt yield is up by nearly half a percentage point since Labour’s general election victory of July 2024, even though the Bank of England base rate is now one-and-a-quarter points lower thanks to five separate interest rate cuts from the Monetary Policy Committee.
Source: LSEG Refinitiv data
“One reason for this bout of bond market jitters is sticky inflation here in the UK, while another is wider, global concern about levels of sovereign, or government, debt across the G7 and beyond. Bond vigilantes fear this could lead fiscal policy – and thus governments – to try and dictate to monetary policy and thus challenge the independence of central banks, with the result that chances are taken with inflation through purportedly growth-friendly policies, as well as headline interest rates which may be kept artificially low in an effort to make governments’ interest bills more manageable. The other concern on the debt front is how an ongoing growth in aggregate borrowing means increased issuance of government bonds, and usually when the supply of something goes up, its price goes down. In the case of bonds, and UK gilts, lower prices mean higher yields, and would-be buyers of government debt may demand higher coupons and interest rates to protect themselves from the perceived dangers of inflation and the increased supply of paper promises.
“It may be of some consolation to Chancellor Reeves that she is not the only finance minister facing this challenge. The yields on Japanese JGBs and French OATs are higher than July 2024 when the Labour government took office, and even US Treasuries have had their wobbles.
Source: LSEG Refinitiv data
“Even so, this may be cold comfort. Bond markets are sufficiently wary of the UK’s economic credentials that it currently costs the country more to borrow money for 10 years than it does either Portugal, Ireland, Italy, Greece or Spain – the so-called PIIGS whose fortunes looked very bleak more than a decade ago, before they all swallowed a very sharp dose of austerity in the form of spending cuts and tax increases.
Source: LSEG Refinitiv data
“That unfavourable borrowing costs comparison serves to highlight the relatively limited room for manoeuvre available to Chancellor Reeves, especially if she looks to stick to her party’s 2024 manifesto promises of no increases in income tax, national insurance or VAT on ‘working people.’
“According to the last Budget, in October 2024, those three items raised two thirds of the government’s £1.2 trillion taxation income. Leaving those alone requires either good economic growth, to lift all boats by increasing the size of the economy and netting more tax income that way, or some fancy footwork on spending, government efficiency and other, smaller items on the revenue register.
“Bond vigilantes would probably be happier with concrete measures such as a penny or two on income tax, or clear spending cuts, regardless of any political ructions caused by a breach of manifesto promises. These measures represent a tangible income that provides the government with the cash it needs to meet the interest bills on its borrowings, and ultimately repay its loans on time, as it is has done without fail since 1672’s Stop of the Exchequer under King Charles II.
Source: HM Treasury
“Over time, the mix of government tax revenue shows relatively little change, going back some 40 years. The available revenue breakdown in the March 1985 Budget is not as detailed as the one to which we are treated now, but the broad shape of it is easy to recognise.
“This may be the result of the political unpopularity of increases in income tax, VAT or national insurance, both on the backbenches in Westminster and the country. The bond markets might be less convinced by less tangible promises of efficiency or productivity gains, which are more likely to falter, harder to quantify and less likely to come through quickly. A wide range of smaller tax increases also raises the risk that the hoped-for income does not materialise in the expected quantity, or on time.
“But what the bond market wants is not necessarily what the voters or party members want. Gilt holders just want to ensure they can be paid, and the economy not sufficiently jeopardised so that issuance goes up a lot in the event of disappointing tax revenues.
Source: HM Treasury
“For all of that, the tax burden has crept up, because spending has gone up faster than GDP and faster than tax income, as the government has found it hard to rein in promises made to the electorate. This tallies with the American economist Thomas Sowell’s acerbic comment that, ‘The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.’
“Demographics are one challenge. The burdens upon the NHS and the pensions system grow as we live longer – certainly longer than we did when the health system was established by Labour’s Attlee government in 1948 and when the old age pension was launched by Asquith’s Liberal administration in 1908 at the rate of five shillings a week, on a means-tested basis, for those over the age of 70.
Source: HM Treasury
“The peace dividend of a lower budget may be over and done, given new commitments to increase defence spending to 3.5% of GDP by 2035, while the growing interest burden on existing borrowings is a further relatively new development.
“The zero-interest-rate policies of the 2010s helped to render manageable the increase in government debt, but the recent vague normalisation of Bank of England base rates has jacked up the interest bill, even if UK government debt is relatively long dated, so there is less refinancing risk here than in the USA, for example, where the profile of US Treasuries is much shorter in structure.
“The NHS has jumped to one-fifth of total government spending, from less than a tenth, in the space of 40 years, and interest has rebounded in the past decade, while a halving of the percentage allocation to defence feels like a thing of the past.
“The difficulty now for the government, in appeasing backbenchers as well as voters, is that the tax take is already at a historically high level relative to GDP, not far from the equivalent figure in Sweden. The days of pretending we can enjoy a Scandinavian-style welfare system on tax levels that are closer to those of the USA are long gone, but voters do not seem content with the levels of public service they receive, either, so the British feel they get the worst of both worlds. Changing this perception is perhaps the biggest task that faces the chancellor even as she looks to keep bond vigilantes at bay at the same time.”
Source: HM Treasury
