UK government borrowing costs have risen ahead of Rachel Reeves’s budget on Wednesday.
Some City investors say the chancellor’s preparations for changing her fiscal rules could be contributing to a febrile mood in financial markets, amid fears that up to £50bn in extra borrowing for infrastructure investment could reawaken bond vigilantes betting against Britain. This includes warnings of a “buyer’s strike” if Reeves handles Labour’s first budget since 2010 badly.
Others, however, say such concerns are overblown, and point to other factors driving the bond markets, and the relatively small changes in UK borrowing costs compared with Liz Truss’s mini-budget.
How much have gilt yields moved?
Benchmark 10-year UK government bond yields – which move inversely to prices – have risen by about 0.2 percentage points in the past month, to about 4.25%. The spread with German government yields has also risen.
Government bonds, known as gilts in the UK, are sold to institutional investors to raise money to cover public spending. The IOUs carry an interest rate, and are repaid after an agreed period of time.
Gilt yields rose by six basis points last Wednesday after the Guardian first revealed Reeves would change the way her debt rules were calculated. Some analysts put this down to the prospect of higher government borrowing.
City traders expect the budget will lead the Treasury’s Debt Management Office to increase its “net financing requirement” – bond sales to cover the government’s cash needs and the refinancing of maturing debt – to about £300bn for the current financial year.
That would be the highest sum sold to investors since 2020, when borrowing surged as the Covid pandemic struck. At that time, the Bank of England was also a significant buyer. Now, however, the bank is also selling bonds as it winds down its crisis-era quantitative easing scheme.
However, investors had already expected about £278bn of sales before the budget, meaning the extra amount is relatively marginal. Still, when supply increases, prices fall.
How does this compare with the past?
The increase in borrowing costs has been relatively modest. Analysts at Deutsche Bank said the rise versus the US and Germany was slightly above average for pre-budget periods since 2006. But it is not outside the normal range, and pales in comparison with Liz Truss’s 2022 mini-budget, when UK borrowing costs surged ahead of other countries.
Back then, investors spoke of a “moron premium” for the UK. Bond yields rose in other G7 countries, amid concerns about high inflation and central bank interest rates, but not by anywhere near as much as in the UK.
The UK’s ability to test the gilt market lingers in the memory of some traders. Analysts at the Dutch bank ING said: “Investors have not forgotten about the short-lived UK prime minister, Liz Truss, when she presented an unfunded budget and gilt yields soared.
“For the moment, such a situation seems averted, and markets appear confident that Reeves will remain broadly committed to budget rules.”
Are there wider factors?
City analysts point to other factors driving the divergence in UK government borrowing costs. Some traders had feared the UK could face more persistent inflation and higher official interest rates than in other nations.
Germany in particular is in a more delicate spot, facing the risk of back-to-back recessions, which could lead the European Central Bank into faster interest rate cuts than the Bank of England.
Britain is not immune though, after inflation fell by more than anticipated in September. Andrew Bailey, the Bank’s governor, has also signalled that Threadneedle Street could become a bit more “aggressive” on cutting the base rate.
Could this affect mortgages?
Jeremy Hunt, the shadow chancellor, has said Reeves’s plans would mean “misery for millions of mortgage holders” by keeping interest rates higher for longer. He said the advice he received consistently while chancellor was that any additional borrowing would have this effect.
Despite the rise in gilt yields in the past month, average two-year fixed residential mortgage rates have fallen modestly, from 5.43% a month ago, to 5.39% on Monday, according to the data provider Moneyfacts.
High street banks price their fixed mortgage deals on money market “swap rates”, which are influenced by expectations for the Bank of England’s base rate. Financial markets expect the Bank will cut its base rate from 5% at present to about 3.75% before the end of next year.
Analysts expect Reeves’s budget will not have a significant impact on the Bank’s decisions, because the chancellor is not expected to dish out vast dollops of near-term inflationary stimulus.
This is largely because Reeves’s plans are to borrow for investment in long-term infrastructure projects. In the nearer term, she is planning large tax rises and some spending cuts to meet her “stability” fiscal rule to match day-to-day spending with revenues. In addition, with inflation cooling, the outlook is different to when Hunt was chancellor.
Analysts at Goldman Sachs wrote in a note to clients: “Our economists expect the government to set a budget that finds a middle ground: it won’t be so tight as to hinder growth and investment, nor so loose as to risk fiscal stability.”
Has Reeves rolled the pitch enough?
Labour has spoken at length about installing “guardrails” to ensure it invests additional borrowing wisely. The government is also not expected to use up all of the additional £50bn headroom a change in the fiscal rules would allow. City analysts expect an increase of about £20bn.
Aiming to smooth jitters in markets, Reeves’s stance stands in contrast to that of Truss, who drove a cart and horses through the UK’s institutional framework by sacking the Treasury’s top official, criticising the Bank of England, and sidelining the Office for Budget Responsibility.
“[Labour] has gone out its way to reassure investors of its fiscal prudence,” said Joe Maher, an economist at the consultancy Capital Economics. “This includes committing to get debt falling as a share of GDP, albeit targeting a different debt measure to the previous government, and not to borrow to fund day-to day spending.”
Labour’s guardrails include strengthening the OBR and the National Audit Office, alongside a new Office for Value for Money, and a National Infrastructure and Service Transformation Authority to oversee large projects.