Of the diverse metaphors used for the global bond market, the best is a grizzly bear — big, scary and often asleep. But if you really wake it up, it can and will rip your face off.
Serious politicians understand the threat posed by the bond market, where a buyer’s strike can drive up a country’s borrowing costs to a point where leaders are forced to change course on their spending plans, or show themselves the door.
Britain received an object lesson just three years ago when Liz Truss’s ill-fated “mini” Budget sparked a sell-off in bonds that sent yields spiralling higher and pushed the country’s pension funds to breaking point — and contributed to the end of Truss’s 44-day premiership.
Next week’s Budget will be another key moment in determining whether this Labour government can show it is a better listener to bond markets. Avoiding something like the 2022 disaster won’t be enough: Labour also needs to avoid a repeat of its first Budget in office a year ago, which sparked lingering concerns over the public finances, eventually helping push the UK’s 10-year borrowing costs to a 16-year high above 4.9 per cent in January.
Yields have since fallen back a little to around 4.6 per cent but remain the highest in the G7, partly because the UK’s stubborn inflation is keeping the Bank of England from cutting interest rates. And the fragility in the market was underlined by a flash sell-off in July as rumours swirled that Rachel Reeves could be ejected from the Treasury, and another this month after a U-turn on a planned rise in income tax.
The UK is “one of the countries which can be disciplined by the bond market right now”, said Salman Ahmed, global head of macro at asset manager Fidelity International. “This government is aware of what happened last October, and is aware of what happened in 2022.”
Some investors argue that a decline in pension-fund ownership of gilts, replaced by flightier hedge funds, adds to the market’s current vulnerability, as does the BoE’s bond-selling programme. Still, the scale and sharpness of the gilt market sell-offs over the past year have been small compared with events that led to Truss’s undoing.
The mood music in the run-up to the Budget has been largely positive for investors. Officials have suggested that the so-called headroom against Reeves’ self-imposed fiscal rules will be increased from the current £9.9bn to at least £15bn and possibly up to £20bn. That, combined with signals on spending cuts and tax rises, sparked a post-summer recovery in gilts.
But the rally came to a screeching halt as the government ditched its income tax plans earlier this month, leaving investors wondering whether the fiscal adjustment would be as big as they had hoped, and whether the measures used to fill the gap might be less reliable revenue-raisers or carried a greater risk of pushing up inflation.
Investors will be focused on how much headroom the government leaves itself. Leaving too little wiggle-room against borrowing rules means small changes in market conditions can require big shifts in policy. But it is not just the number that counts.
“How it is achieved matters as well,” said Tomasz Wieladek, chief European macro strategist at T Rowe Price. “Headroom of £15bn that is achieved through fiscal policies which are seen as credible will have a more positive market impact than a £20bn headroom backed by uncertain sources of tax revenue.”
There are also important implications for the BoE, whose plans for interest rates are traditionally the bond market’s central concern.
Traders currently expect just two quarter-point rate cuts from the current 4 per cent by the end of next year. A Budget that weighs on growth without fuelling inflation would allow the BoE space for bigger reductions, pulling down borrowing costs and making it less likely that the bond bear is awakened.
But a Budget deemed inflationary, if it leans on new duties and levies, could push yields higher and the market back into less comfortable territory.
Another worry for investors is that the Budget pushes more of the fiscal consolidation into future years. Reacting to the income tax news, Morgan Stanley’s Bruna Skarica warned that it suggested a “higher likelihood of backloaded consolidation”, which would mean that the UK continues to get punished by the bond market with a “fiscal risk premium” in its borrowing costs.
The bond market is harder to disturb than some commentators pretend, and most gilt investors do not expect the upcoming Budget to deliver a Truss-style wake-up.
But nor do they want to leave the bond bear stirring.
Britain in numbers
Nerves over the Budget are also showing up in the appetite for UK stocks, strategists say. Despite the blue-chip FTSE 100 stock index reaching a string of record highs this year, domestic investors have been pulling money from UK equity funds at a rapid clip.
“When you get a heightened sense of impending doom, it is understandable that people take a bit of money out,” Charles Hall, head of research at Peel Hunt, told my colleague Emily Herbert.
On Budget day, the stock index to watch is not so much the FTSE 100, which is dominated by multinationals and whose constituents derive most of their revenues outside the UK, but the FTSE 250, whose companies are more exposed to domestic demand.
An early feel on the economic impact of the overall Budget measures will probably show up there, in the stock market’s squeezed middle, as well as in the value of the pound, which has already fallen to a more than two-year low against the euro in the run-up to the fiscal event.
It has been dragged lower by the same things that could help the bond market — a Budget expected to keep a lid on inflation but also weighing on growth — which is not all good news for the rest of us.
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