The bond market tantrum is a harmful verdict on the budget

Rachel Reeves’s big job on Wednesday, alongside working out how much money to spend and how to raise it, was making sure she didn’t upset the bond markets. The last thing she wanted was a repeat of Liz Truss’s mini-budget two years ago, where an over-ambitious and ill-thought-out set of measures badly spooked investors, leading first to a rapid run-up of gilt yields, second to a collapse in the value of sterling and third to Truss and her chancellor, Kwasi Kwarteng, losing their jobs.
Reeves failed. It was not a Truss-style epic fail and she and Sir Keir Starmer are in no danger of defenestration. It was bad enough, however, to be counted as a serious black mark against her, all the more so given that she knew in advance, and had repeatedly emphasised, that even the faintest echo of the Truss debacle had to be avoided.
It calls into question her understanding of just how sensitive investors are to the difficulties of the UK’s economic position and her wider knowledge of what makes bond markets tick. When Labour politicians pop up over the next few days and try to play down the significance of the market reaction, bear one thing in mind: when a chancellor has to make an unscheduled appearance on the financial news channel Bloomberg TV the day after a budget to try to calm the markets, as Reeves did on Thursday afternoon, then that budget cannot be counted a success.
Truss and Kwarteng’s woes were made worse by their decision not ask the Office for Budget Responsibility its opinion on their tax and spending plans. Reeves’s problems were also triggered by the OBR, although this time by its verdict. Marcus Jennings, fixed-income strategist at Schroders, talked me through on Times Radio on Thursday morning what had happened. He pointed out that while Reeves was on her feet gilt yields fell back slightly: good news for the government. Traders saw immediately how much more borrowing Labour planned — about £140 billion extra over the next five years — which should on its own have been enough to send markets into a spin. But they also saw how much extra tax was being raised, a reassurance that there would be a solid counterweight to the borrowing.
When Reeves sat down, however, yields quickly started to go in the other direction. What happened, Jennings said, was that the OBR posted its response to Reeves’s plans and investors did some speed reading. They did not like what they saw, in particular the gloomy verdict on growth. The killer phrase: the plans would “leave GDP largely unchanged in five years”. This was not what Reeves, who had pledged to use the budget to get the UK economy growing faster, wanted to hear.
• Britain has PTSD from Liz Truss’s budget, says Labour minister
That was behind the immediate sell-off on Wednesday afternoon but yields continued to move up on Thursday and Friday (with a few hours of calm here and there) as more bits of the OBR’s judgment were unpicked. The watchdog pointed out that even though there were hefty tax rises and a lot more borrowing it was not clear that the government had all the money it might need over the next five years. Detailed departmental spending plans had only been set for one year and future income assumptions were “still based on seldom-implemented fuel duty rises”. Paul Johnson, the outgoing director of the Institute for Fiscal Studies, put it more bluntly, saying that Labour was guilty of the “same silly game-playing” as the Conservatives by not being honest with the public about the true scale of future spending and how it would be paid for.
Why all this fuss about financial markets, you might think. Numbers on City screens are a world away from the day-to-day delivery of public services. Who cares what happens in the trading of bonds that have already been issued? In any event, the moves looked tiny. From Wednesday to Friday the yield on the UK 10-year gilt rose by about one third of one percentage point, hardly the near one-and-a-half percentage point leap in the days after the Truss mini-budget.
• Rachel Reeves ‘playing silly games’ says IFS chief — as it happened
It might look small, though, but it is significant. Bond yields normally move very slowly and not by very much. Like share prices, they are a reflection of many different investors’ views on lots of different factors but principally their view on what will happen to inflation. That is an odd idea to get your head around, but it makes sense when you think about what a bond offers. It gives you a fixed rate of interest over a certain period of time. If you have bought a bond that pays 3 per cent, 2 per cent inflation is OK: you are getting a return of 1 per cent a year above inflation. If the outlook on inflation changes to 5 per cent, your bond is much less valuable. When bond yields go up, as they did in reaction to Wednesday’s budget, investors are signalling that they think that inflation, and by extension interest rates, will stay higher than expected in the UK, and for longer.
Higher rates have a knock-on effect. The OBR already thinks the government will be spending about £100 billion a year on interest payments over the next five years. It also looked at what would happen if interest rates moved up. They chose to look at rates 1.3 per cent higher than forecast. The effect is dramatic. It would push annual interest payments to £143 billion in five years’ time and completely blow Reeves’ fiscal target of having day-to-day spending covered by government income.
The other thing to bear in mind is that the Truss move was exaggerated by a pensions liquidity crisis. That meant that there were lots of forced sellers in the market at just the wrong time. Reeves has no such excuse. This is just the market’s verdict on her plans. Another way to look at it is how UK bonds are trading against their rivals. After this week’s moves, the yield on the UK 10-year bond is just over two percentage points higher than the German equivalent, the highest it has been since the Truss mini-budget. Given that the German economy is facing a really tough time with a collapse in manufacturing output, that is not a rosy judgment.
It is difficult to predict what will happen next. Bond markets have been volatile all year thanks to uncertainties about how fast inflation is coming down in western economies, and the looming US election has added to the instability. There is also genuine disagreement among economists about what will happen to UK interest rates and a rate decision from the Bank of England coming on Thursday. Reeves deserves credit for trying to tackle the UK’s growth problem by putting more money into public services and investment but the bond markets’ mini-tantrum is a sharp reminder that she is not the sole master of her destiny.