(And why Liam Gallagher isn't helping)
Rachel Reeves may not actually be electric, and it’s debatable whether she is in a family of eccentrics, but financial systems are already feeling shocks. The UK’s borrowing costs have significantly increased as investors get nervous about the Labour government's upcoming Budget, widening the yield spread between UK and German bonds to its largest gap in over a year.
Known as Gilts, UK government bonds are what let the government borrow money – and the amount the government has to pay to borrow is crucial to mortgage rates, as they affect what are known as “swap” rates, which mortgage lenders pay to other institutions, to acquire funding for future lending. In simple terms, swap rates are a best guess as to what the market thinks interest rates will be in the future, and they tend to move in tandem with Gilt interest rates.
With just three weeks until her inaugural Budget, bondholders believe the UK Chancellor must tread carefully if she plans to maintain her borrowing and investment strategies without inciting a sell-off in UK government bonds.
The current spread between UK and German 10-year bond yields has reached 1.94 percentage points, the highest since August 2023. This is driven by investor worries that Reeves may expand the national debt and concerns about persistent inflation.
And those inflation worries haven’t been helped by the headline-grabbing Oasis reunion – figures out today show that UK non-essential spending has hit a new record for the year of 2.7% according to Barclays – driven by a mad scramble for surge-priced Oasis tickets.
“Financial markets won’t afford much room for additional borrowing,” Mark Dowding, chief investment officer at RBC BlueBay Asset Management told the Financial Times. He stressed that Reeves needs to manage her Budget plans cautiously; otherwise, the bond market may restrict her ability to enact much of Labour’s agenda.
Reports suggest Reeves might relax her borrowing rules to fund increased investments in the Budget on October 30, leading to a rise in the 10-year gilt yield from 3.75 percent in mid-September to 4.2 percent. Dowding also pointed out that memories of the 2022 min-budget—when former Prime Minister Liz Truss’s borrowing plans without funding caused market panic—remain fresh in the minds of investors.
The Chancellor is facing challenges in identifying tax hikes to cover what she describes as a £22 billion shortfall in day-to-day spending. She has scaled back plans to increase taxes on non-domiciled individuals and chosen not to subject private equity staff to the top tax rate of 45p, following advice that these moves could backfire.
UK public borrowing has exceeded predictions this year, partly due to higher-than-expected expenditures. Some analysts anticipate the government might need to issue more gilts in the financial year ending in March 2025 than the projected £278 billion.
In response, Reeves has attempted to calm investor anxieties by asserting that she is not in a rush to spend and will implement "guardrails" to ensure government funds are used for sensible investments. Tomasz Wieladek, chief European economist at asset manager T Rowe Price, emphasised that such reassurances are crucial to provide investors with certainty about future gilt issuance, especially if borrowing rules are modified.
Another factor influencing the widening gap between UK and German bond yields is the expectation that the European Central Bank will reduce interest rates more quickly than the Bank of England to stimulate the Eurozone economy.
Despite these remarks boosting short-term government debt, longer-term gilts remain under pressure, given their sensitivity to fiscal policy. The Treasury has explored changes to fiscal rules, such as limiting the impact of losses on the Bank of England’s gilt portfolio and removing liabilities linked to government investment plans like the proposed GB Energy project.
Reeves has indicated that she plans to address the UK’s “low investment” levels, hinting that the government could adjust its debt targets to account for public sector assets, not just liabilities. This potential rethinking of the fiscal framework has received backing from the Institute for Public Policy Research, which suggested revising the rule requiring debt reduction between forecast years four and five. According to their analysis, this shift could provide an additional £57 billion in borrowing capacity.
However, the think tank recommended that part of this extra headroom should be retained as a safeguard against economic uncertainties. The Treasury stated that the Budget would prioritise economic stability, maintaining fiscal rules that balance day-to-day spending with revenues and aim for debt reduction within five years.
This situation is occurring alongside debates on capital gains tax (CGT) hikes and rising mortgage rates due to government borrowing. The property market, while showing signs of activity, might face setbacks if the new Budget is poorly managed.
In her Budget preparations, Reeves is contemplating expanding government borrowing significantly, potentially releasing up to £50 billion by changing borrowing limits. Treasury analysis suggests even minor fiscal loosening could push up interest rates by up to 1.25 percentage points, impacting both consumer and business borrowing costs.
The analysis, reflecting the Treasury’s current stance, emphasises that changes to fiscal rules could have a substantial effect on borrowing costs. If Reeves moves forward with her plans, she may unlock a significant budget for government spending, but this comes with potential risks for the broader economy. Former Chancellor Jeremy Hunt has warned that increased borrowing would extend the duration of high interest rates, affecting mortgage holders.
Labour leader Sir Keir Starmer has hinted that the Budget could be “painful,” indicating potential tax increases to address the deficit. The Institute for Fiscal Studies (IFS) also raised concerns, cautioning that relaxing fiscal rules might lead to further rate hikes and labelling Reeves's approach as risky. However, the IFS did acknowledge that borrowing for capital investment, rather than immediate spending, could stimulate growth if executed correctly.
The Treasury’s official paper outlines the potential impact of additional borrowing on interest rates. Using the OBR’s macroeconomic model, they estimate that a 1% increase in GDP borrowing could elevate rates by 50 to 125 basis points, influenced by inflation and other economic factors. While the impact may vary, the general consensus is that fiscal expansion could push up borrowing costs and inflation, prompting the Bank of England to respond with higher rates.
Picture: UK Parliament, This file is licensed under the Creative Commons Attribution 3.0 Unported license.
