Bond markets ‘will not forgive heavy borrowing’ in Reeves’s budget

Investors in government bonds “will not give the benefit of the doubt” to Rachel Reeves if they think the chancellor is borrowing too much in the budget this month, according to the City economist advising the Institute for Fiscal Studies.
There was “material concern out there” among investors in gilts ahead of the budget, according to Ben Nabarro, chief UK economist at Citibank, who worked with the IFS on its latest assessment of Reeves’s tax and spending options.
Referring to the catastrophic mini-budget of two years ago, which sent gilt prices plunging and led to an emergency bailout by the Bank of England followed by the resignation of Liz Truss as prime minister, Nabarro said: “International investors are not prepared to give the government the benefit of the doubt.”
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He went as far as saying “the risk of a buyers’ strike” among gilt investors was already “beginning to emerge”, but later retracted that comment, while adding that the UK did need to be careful.
Gilt investors have shown signs of nervousness over the past few weeks. The yield on ten-year government bonds, which moves inversely to the price, has risen by 0.32 percentage points to 4.18 per cent in the past month in spite of growing expectations of cuts in official interest rates. The yield gap between the UK and comparable bonds in Germany has widened to its largest level in more than a year. In recent days, the pound has also been sinking back lower from a late September high of $1.34 to around $1.31.
A blow-out in bond yields after Kwasi Kwarteng announced unfunded tax cuts in September 2022, when he was chancellor, mushroomed into a full-blown crisis as pension funds scrambled to unwind leveraged hedging arrangements known as LDI, or liability driven investment. This fuelled a self-feeding selling spiral. The gilt market today was “more resilient to those risks”, Nabarro said.
Pension funds have since reduced their leveraged LDI exposure so that the risk of a repeat of that exacerbating factor is thought to be unlikely. However, Nabarro warned that the UK was still more vulnerable than other countries, such as Japan or eurozone nations, which were supported by strong domestic appetite for government bonds and less reliant on overseas support.
He also warned that any attempt in the budget to stimulate demand too strongly could be problematic if it drove up inflation and interest rate expectations. Extra borrowing to fund investment needed to be dialled up “gradually” he added.
The warning came as the IFS described Reeves as in an “unenviable” position and looking at being required to find as much as £25 billion a year of additional tax revenues by 2028-29 if she wants to lift spending in unprotected departments like education and justice in line with national income.
The Treasury said: “The budget will be built on the rock of economic stability, including robust fiscal rules that were set out in the manifesto. These includes moving the current budget into balance, so that day-to-day costs are met by revenues, and debt falling as a share of the economy by the fifth year.”
One other factor making the UK uniquely vulnerable was the reduction in demand for long-duration gilts as traditional defined benefit pension funds were wound down, the IFS/Citi report said. Also the net selling of the Bank of England through its quantitative tightening programme would increase reliance on foreign investors. The “goodwill” of the gilts market could not be relied upon, it said.
Some pension funds are supportive of reforms to the fiscal rules so that some publicly owned assets could be used to offset liabilities in calculations of net public sector debt. Schemes including the Universities Superannuation Scheme and the National Employment Savings Trust backed a campaign on Wednesday to change the rules in order to make it easier for the government to co-invest with them in green energy and infrastructure projects.
“Reforming the fiscal rules to treat unlisted productive assets as an asset will help incentivise long-term public investment in the net-zero transition, creating the conditions for National Wealth Fund and Great British Energy to crowd in pension capital at scale,” the schemes said in a joint statement.