Gilt yields spike on UK government’s precarious finances

The UK government bond (gilt) market sold off aggressively on 2 July on the back of traders’ and investors’ concerns over the potential for further fiscal deterioration.

There was speculation that the UK Chancellor, Rachel Reeves, was to be replaced – chiefly driven by her distressed appearance in the House of Commons during Prime Minister’s Questions.

The market narrative was that any replacement might not be as committed to the government’s fiscal framework, meaning the potential for even higher borrowing and more gilt issuance to come.

Prime Minister, Keir Starmer, eventually said that Reeves would remain Chancellor for “years to come”, with Westminster’s official line being that her obvious upset reflected a personal issue.

On a net basis, the yield on 10-year UK government bonds rose 15.8 basis points (bp) while the 30-year yield increased by 19bp. The price of the 2061 maturity gilt fell by over 4%. Sterling fell back against both the US dollar and the euro.¹

Backtracking

The UK government’s revenues are in a challenging position. The Labour government has recently performed U-turns on pledges to reduce winter fuel payments and disability benefits.

Commitments to increase public sector pay, alongside higher-than-anticipated interest payments have together conspired to erase any extra fiscal headroom that the Chancellor had, to stay within fiscal rules.

Markets have taken the view that the government is politically unable to follow through on promises i.e. reduce welfare spending, ramp up defence spending and not increase income taxes.

Despite a huge majority in parliament, the Labour government appears to have lost any room for manoeuvre when it comes to fiscal policy. Markets sense that abandoning the fiscal rules – allowing the deficit to increase relative to the previous baseline – might become politically tempting.

Therefore, that means an increased fiscal risk premium in UK government bonds, which recalls the dramatic period in September 2022, when markets responded to then the Prime Minister Liz Truss’s attempt to cut taxes to boost economic growth. 

Between a rock and a hard place

Something will need to give, and the political calculus is complicated by the apparent rise in the electorate’s support for the Reform Party. Keeping the markets on side is at odds with maintaining support amongst Labour’s traditional base. The least painful move might be to simply abandon its 2024 election manifesto promises not to raise income tax.

The UK’s fiscal position is not great. The budget deficit is more than 5% of GDP - not as bad as in the US but equivalent to the projected deficit in France. Government spending is at 44% of GDP, less than in other European nations, but higher than in the US, Canada, and Japan.

The structural issue seems to be the welfare bill with growing numbers of people claiming disability allowance and other long-term sickness benefits. As in other European economies, the population is ageing and there is a huge political focus on the cost of immigration.

Looking forward, the leadership needs to display a firm commitment to fiscal stability and Starmer needs to make more forceful arguments about the imperative of getting welfare spending under control. Despite having a large majority in parliament, many of the parliamentary Labour party prefer a generous welfare state to the long-term stability of public finances. 

What’s next?

Following Starmer’s assertion that Reeves will remain in office, gilt yields eased back, albeit marginally. The Debt Management Office has pledged to reduce issuance of longer maturity gilts. However, yields are higher than in other markets and that adds to negative debt dynamics.

The summer should be quiet, but markets will look towards the Autumn Statement and what new policies can be introduced to ensure the UK stays within its fiscal rules. Higher bond yields are sobering for politicians and the government will be keen to restore confidence, not least because the Bank of England might be hesitant to cut interest rates with the financial outlook being so uncertain.

Yields on long-dated gilts are arguably offering good value. They are at their highest since before Tony Blair became Prime Minister in 1997. Starmer needs to learn some lessons from Blair’s ‘New Labour’ if he wants to pursue his broader political ambitions – get the markets onside and have a laser focus on fiscal stability. He is some way off that today, suggesting the gilt market will remain very sensitive to any signs of political or fiscal weakness in the months ahead.