I’m the captain now
Forget the fiscal rules, Britain’s government now takes orders from bond vigilantes
Quick column (or perhaps rant) from me on the mess today in Parliament and the gilt market. A bit more Economist-style than usual for this Substack, forgive the formality!
They can’t say they weren’t warned. After an embarrassing backbench revolt on welfare cuts and a messy prime minister’s questions, yields on gilts spiked. Within hours, they rose around 10 basis points1 (0.1 percentage points, see chart 1)—a move that was mostly specific to Britain.
The cause of these ructions is not hard to deduce. Despite its 166-seat working majority, Britain’s government failed to push through a set of welfare cuts worth under £5bn per year, in the context of a working-age welfare bill projected to rise far more than that by 2029. Fiscal prudence has taken a back seat to party management.
This was the latest in a now worryingly frequent set of squalls in the gilt market. Yields rose by 25 basis points after October’s budget, where Rachel Reeves, the chancellor, loosened her fiscal rules to raise borrowing by £30bn. They spiked again in January, as anxiety about Donald Trump’s big-spending agenda yanked bond yields up globally. Britain was hit especially hard, and Ms Reeves was forced to rush out growth-friendly announcements like a third Heathrow runway to change the narrative. Britain was also particularly exposed to the swings after Mr Trump’s “Liberation Day” tariff announcements.
One reason the latest moves are especially troubling is that they reflect not just a response to a particular policy–the amounts involved in the welfare cuts were ultimately not vast–but a wholesale reassessment of whether the Labour party can be trusted to get Britain’s public finances in order. However strong Ms Reeves’s commitment may be, the broader party does not appear to be behind her. Nor, potentially, is Sir Keir Starmer. The prime minister initially declined an opportunity in parliament to guarantee her job was safe. (He eventually did, later in the afternoon.)
Across the world, governments are spending big and bond yields are rising. Isabel Schnabel of the European Central Bank spoke in February of a “global bond glut”, a reverse of the 2010s-era dynamic where seemingly insatiable demand for bonds from savers pushed yields down. In Britain, the investor base in gilts has also shifted more towards flighty foreign capital in recent years.
That sets the stage for a difficult budget in the autumn. The typical Westminster debates, which focus on the government’s “headroom” against its fiscal rules, will be something of a mirage. That headroom is around £10bn in theory, though the reversals on welfare will have narrowed that sum considerably. Higher yields will eat away too, as will the impact of US tariffs on growth, not yet incorporated into the Office for Budget Responsibility’s forecasts. The OBR is also looking at its productivity projections over the summer, which are more optimistic than the vast majority of independent forecasters, and may move those down too, potentially adding tens of billions to the hole.
But focusing on self-imposed fiscal rules is a luxury that Britain’s government can no longer afford. If the goal of setting such rules was to persuade bond markets that Britain’s fiscal conditions were in safe hands, and investors could safely treat budgetary news as a non-event (as has usually been the case in past decades), then they have manifestly failed. The Liz Truss debacle in 2022 had already made the situation challenging, but this government’s choices have not helped either.
Gilt vigilantes are now watching. Staving off ever-higher yields will now be a central priority for this government. Already, higher debt servicing costs account for a bit under half of the rise in government spending since 2019. Britain’s bonds have higher yields than any other G7 economy (see chart 2), having been middling before the Covid pandemic. Learning to think that way will be difficult for Labour’s MPs, many of whom came of age politically in the low-rate environment of the 2010s, when government debt was cheap. But it will be essential.
Ever since the Brexit vote, the question of whether to treat Britain like an emerging market has been a running joke among investors. Briefly, during Liz Truss’s tenure, Britain behaved like one–gilt yields spiked as sterling sold off, the telltale sign of EM market dynamics. But this government has now set itself up to be the first British government in decades whose policy programme will be subject to such constant scrutiny by the bond market. Mr Starmer and his colleagues may soon yearn for the luxury of being considered boring.
Up to 15bps at one point, but the move has subsided a bit as I publish