Will bond investors punish Rachel Reeves with a market crash like the one that happened with Liz Truss?

Will bond investors punish Rachel Reeves with a market crash like the one that happened with Liz Truss?

Yields on 10-year government bonds have increased over the last month but are still similar to levels seen before other budget announcements.

The UK government is facing higher borrowing costs as Rachel Reeves prepares for her budget on Wednesday.

Some investors in the City believe that Reeves’s plans to change her financial rules are making the financial markets nervous. They worry that if the government borrows an extra £50 billion for infrastructure projects, it could lead to a situation where investors bet against Britain. There are concerns that if Reeves doesn’t manage Labour’s first budget since 2010 well, there could be a “buyer’s strike” where investors refuse to buy bonds.

However, others think these worries are exaggerated and point to different reasons affecting the bond markets. They also note that the recent changes in UK borrowing costs are not as significant compared to the changes that happened after Liz Truss’s mini-budget.

How much have gilt yields changed?

The yield on 10-year UK government bonds, which go up when prices go down, has increased by about 0.2 percentage points over the past month, reaching around 4.25%. The difference between UK and German government bond yields has also gone up.

In the UK, government bonds are called gilts. They are sold to large investors to help fund public spending. These bonds pay interest and are paid back after a certain time.

Last Wednesday, gilt yields went up by six basis points after the Guardian reported that Reeves would change how her debt rules are calculated. Some analysts believe this is because the government might need to borrow more money.

Traders in the City expect the budget will cause the Treasury’s Debt Management Office to raise its “net financing requirement.” This means they will need to sell more bonds to cover the government’s expenses and pay off existing debt, reaching around £300 billion for this financial year.

This amount would be the highest sold to investors since 2020, when borrowing increased sharply due to the Covid pandemic. Back then, the Bank of England was a big buyer of bonds, but now the bank is selling bonds as it ends its crisis-era financial support program.

However, investors were already expecting about £278 billion in bond sales before the budget, so the extra amount is not very significant. Still, when there are more bonds available, prices tend to go down.

How does this compare with the past?

The rise in borrowing costs has not been very large. Analysts from Deutsche Bank said that the increase compared to the US and Germany is just slightly higher than usual for times before a budget since 2006. However, it is still within a normal range and much lower than during Liz Truss’s mini-budget in 2022, when borrowing costs in the UK went up sharply compared to other countries.

At that time, investors talked about a “moron premium” for the UK. Bond yields in other G7 countries also went up because of worries about high inflation and central bank interest rates, but not as much as in the UK.

Some traders still remember how the UK tested the gilt market. Analysts at the Dutch bank ING said, “Investors haven’t forgotten about Liz Truss, who was a short-term prime minister. When she presented a budget without funding, gilt yields shot up.”

“Right now, that kind of situation seems unlikely, and the markets look confident that Reeves will stick to budget rules.”

Are there bigger factors?

City analysts mention other reasons why UK government borrowing costs are different. Some traders were worried that the UK might have longer-lasting inflation and higher interest rates compared to other countries.

Germany, on the other hand, is in a tricky situation and might face two recessions in a row, which could cause the European Central Bank to lower interest rates faster than the Bank of England.

However, Britain is also affected. In September, inflation dropped more than expected. Andrew Bailey, the governor of the Bank of England, has hinted that they might consider lowering the base rate more aggressively.

Could this affect mortgages?

Jeremy Hunt, the shadow chancellor, has warned that Reeves’s plans could bring “misery for millions of mortgage holders” by keeping interest rates high for a longer time. He said that when he was chancellor, he was told that any extra borrowing would lead to this outcome.

Despite an increase in government bond yields last month, the average rate for two-year fixed residential mortgages has slightly decreased from 5.43% a month ago to 5.39% as of Monday, according to Moneyfacts.

High street banks set their fixed mortgage rates based on money market “swap rates,” which are affected by what people expect the Bank of England will do with its base rate. Financial markets think the Bank will lower its base rate from the current 5% to about 3.75% by the end of next year.

Analysts believe that Reeves’s budget will not greatly influence the Bank’s decisions because the chancellor is not expected to make big changes that would increase inflation soon.

This is mainly because Reeves plans to borrow money for long-term infrastructure projects. In the short term, she intends to raise taxes and cut some spending to ensure her budget matches everyday spending with revenue. Additionally, since inflation is decreasing, the situation is different from when Hunt was chancellor.

Analysts at Goldman Sachs noted that they expect the government to present a budget that strikes a balance: it won’t be so strict that it harms growth and investment, nor so relaxed that it risks financial stability.

Has Reeves done enough to convince people?

Labour has talked a lot about setting up “guardrails” to make sure it spends borrowed money wisely. The government is also not expected to use all of the extra £50 billion that a change in rules would allow. Analysts think there will be an increase of about £20 billion.

To calm market fears, Reeves’s approach is very different from Truss, who disrupted the UK’s financial system by firing the top Treasury official, criticizing the Bank of England, and ignoring the Office for Budget Responsibility.

“Labour is trying hard to assure investors that it will manage money wisely,” said Joe Maher, an economist at Capital Economics. “This includes a promise to reduce debt compared to the economy’s size, even though they are focusing on a different debt measure than the last government and not borrowing to pay for everyday expenses.”

Labour’s “guardrails” include making the Office for Budget Responsibility and the National Audit Office stronger, creating a new Office for Value for Money, and setting up a National Infrastructure and Service Transformation Authority to manage big projects.

Published: 29th October 2024

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