A global bond market sell-off sparked by US debt fears has put fresh pressure on UK chancellor Rachel Reeves and her self-imposed fiscal rules.
Yields on the 30-year gilt are approaching a 27-year high and closed at 5.48 per cent on Friday, following gains in US and Japanese government bond yields in recent weeks.
Meanwhile, UK 10-year gilt yields, the benchmark debt watched most closely by investors, have risen more than equivalents in any other G7 country barring Japan over the past year.
With UK economic growth still sluggish, investors have warned that Reeves will need to cut public spending further or raise taxes again to meet her rule to balance day-to-day spending with revenues by 2029-30.
“Gilts remain in the crosshairs,” said Anders Persson, head of global fixed income at asset manager Nuveen.
Higher borrowing costs are whittling away at Reeves’ fiscal room for manoeuvre just as she is also facing fierce political pressure to relax her grip on spending.
Prime Minister Sir Keir Starmer last week announced plans to reverse at least some of the £1.5bn of annual savings Reeves earmarked from the removal of winter fuel payments from all but the poorest pensioners.
He also wants to end the two child benefit cap, at a potential cost of up to £3.5bn a year by the end of the decade. Deputy prime minister Angela Rayner has suggested hiking taxes, particularly on the better off, to fill the fiscal hole.
Britain, like other countries in Europe, is also being forced to increase spending on defence in response to calls from the Trump administration.
Global events have made life harder for Reeves this year. US Treasuries have sold-off in response to concerns about Donald Trump’s trade war and the huge tax cuts he is pushing through Congress. Similar rises in yields have been seen in Bunds after Germany’s leaders struck a historic deal to fund investment in the country’s military and infrastructure. Yields move inversely to prices.
Gilts’ “elevated correlation with Treasuries and Bunds has left them vulnerable in recent fiscal-driven sell-offs,” Persson said. “But UK-specific risks are amplifying the pain.”
Persson pointed to the UK’s stubborn inflation, reflected in the Bank of England’s cautious stance on interest rates and evident in the three-way split among policymakers this month. He said the split suggested a slow pace of rate cuts “despite signs of weak underlying growth”.
But some analysts argue that policy mis-steps have weakened the country’s budgetary resilience, leaving it acutely vulnerable to bond market turmoil.
These include Reeves’ decision to run with just £9.9bn of headroom against her day-to-day spending rule, as well as Labour’s pledge that it will not raise key revenue raisers such as VAT or income tax.
A bond-selling programme by the BoE is also adding to nerves about the appetite among big investors for long-dated debt.
Isabelle Mateos y Lago, chief economist at BNP Paribas bank, said: “At times like this markets tend to look for the outliers — places where things could go wrong fiscally — and unfortunately the UK finds itself in this category.”
An “exogenous shock” to the global economy could lead the Office for Budget Responsibility, the UK fiscal watchdog, to downgrade its forecasts and force more budgetary tightening, she said.
The strictness of Reeves’ fiscal rules “actually damages the UK’s credibility because they have to hurt themselves so much to meet them”, Mateos y Lago added. “It is an unfortunate place for the UK to be.”
The Treasury said: “The fiscal rules are non-negotiable. We put them in place to create stability, and support investment. We’ve seen what happens when fiscal rules are put to one side, and we are not going to put the nation’s finances at risk.”
Andrew Goodwin, UK economist at consultancy Oxford Economics, estimated that market movements since Reeves’ March 26 Spring Statement have carved a fresh £5bn hole in her £9.9bn of headroom.
“They have been authors of their own misfortune by leaving so little headroom,” he said.
Some investors said loosening the rules and easing pressure for more spending cuts or tax rises would be risky, however.
“The UK is already out of fiscal space,” said Mark Dowding, fixed income chief investment officer at RBC BlueBay Asset Management.
“Any attempt to water down or scrap the framework runs that risk of a market tantrum given the legacy of what happened with Liz Truss,” he added, referring to the then prime minister’s ill-fated “mini” Budget of September 2022.
Peder Beck-Friis, economist at Pimco, added: “It looks likely that they will have to add more fiscal tightening in the autumn.”
A further threat stems from the OBR’s forecasts for longer-term UK growth, which are widely seen as being out of line with other analysts’ assessments because of a stronger view of Britain’s productivity outlook.
Any downgrade to its productivity growth predictions, which could come as soon as October, would deal a further blow to the straitened public finances.
Ruth Gregory, economist at research company Capital Economics, said that if the OBR cut its forecast for potential productivity growth from 1 per cent a year between 2025 and 2029 to 0.8 per cent a year, “that could reduce the fiscal headroom by about £20bn”.
“Reeves took a pretty big bet last October by leaving herself with almost no headroom,” said Paul Johnson, head of the Institute for Fiscal Studies think-tank. “It doesn’t look like she will get away with it.”
Data visualisation by Keith Fray
