To say Rachel Reeves has had a bad week would be an understatement. A bond market sell-off early last week caused media hysteria with headlines proclaiming, “UK 10-year borrowing costs hit highest level since 2008” and “Why spiralling borrowing costs spell trouble for Rachel Reeves”.
Higher bond yields means it’s more expensive for the government to borrow. And as the budget planned to borrow £142bn over the next five years, Reeves now faces a real headache over how this will impact government spending plans. Speculation is already rife that more tax rises or spending cuts are on the way to ensure the government can abide by its own fiscal rule to bring down debt.
Politically, the timing couldn’t have been worse. The start of the sell-off coincided with a British Chambers of Commerce (BCC) survey showing that over half of firms planned to raise prices due to tax increases announced in the budget. Worse still, Reeves was in China on a preplanned trip to boost economic ties. Tories immediately criticised her for “fleeing to China”, ducking responsibility for the crisis and forcing the Prime Minister to issue a statement that Reeves will be staying in her post until the next election. Still, the crisis has made the Chancellor’s future look very uncertain and led to inevitable comparisons between her budget and Liz Truss’ calamitous ‘mini-budget’.
So should we start rolling out the lettuces?
Not quite. This saga is the epitome of the saying that correlation does not equal causation; looking further afield to Germany, Spain, Japan and the rest of the world we can see that global bond yields are also soaring.
The root cause of this is the incoming return of Donald J Trump as President of the United States. It may seem ridiculous that one man could have such an influence on global markets until you look deeper at some of the figures. Most people know that the American economy is number one in the world by GDP size, but that hides the fact it makes up 26% of global GDP (for reference the whole of the EU makes up just 13% of global GDP and the UK - which is the sixth largest in the world - makes up just 2.17%). When you then consider that global trade is conducted using the US dollar, then you start to realise how much influence one country has on the world’s economy.
Combined with Trump’s toxic mix of fighting with the Federal Reserve and its Chief, Jerome Powell, and threatening to implement global tariffs between 10 and 25%, investors are betting heavily that inflation will soon rear its ugly head. Higher inflation means higher interest rates and that means current bonds with lower yields look like a bad bet, so investors have been dumping them.
But while the majority of this issue has been imported from America, Reeves isn’t completely off the hook; her budget left just £10bn of fiscal headroom, far less than what most economists at the time would call a comfortable amount. If yields rise any further she will need to consider either revising her fiscal rules or a second round of tax rises, both of which are deeply unpopular. Fortunately for her, inflation is still trending downwards in the UK which makes interest cuts still likely this year and has helped lower bond yields over the past few days. The latest government bond auction was still oversubscribed meaning there are likely to be plenty of investors clamouring for more.
However, with the US set for more turbulence, Reeves will have to figure out how to reign in borrowing while delivering growth. Until both are satisfied the bond market may again threaten the stability of the government.
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