"Silly games" pushes rates towards peak hit by "lettuce" Liz Truss
The UK’s borrowing costs surged to their highest point this year yesterday, following intensified selling in the government bond market. This rise was triggered by investor concerns over the increased borrowing plans laid out in Chancellor Rachel Reeves' recent Budget that amount to an extra £142 billion over the next five years.
The yield on the 10-year gilt rose by 0.1 percentage points to 4.45%, reaching a high of 4.50% earlier. The two-year gilt yield also climbed by 0.11 percentage points, reaching 4.42%. At the same time, the British pound depreciated by 0.6% to $1.288 against the US dollar, marking its lowest level in over two months.
These market movements followed a volatile session on Wednesday, during which initial optimism around Labour's first Budget in over a decade quickly shifted as investors digested the scale of additional government borrowing. The 10-year yield had initially dropped to 4.21% during Reeves' address – however rates started to climb again as the penny sunk (as has the pound, falling the most in one day for 18 months).
Analysts attributed the market response to the projected £28 billion in additional annual borrowing, which the Office for Budget Responsibility (OBR) described as "one of the largest fiscal loosenings of any fiscal event in recent decades."
According to Ben Nicholl, senior fund manager at Royal London Asset Management, some investors feel the Budget’s assumptions are overly optimistic. He told the Financial Times: “There is a fear, I think, that Labour will have to come back to the bond market in April, to increase borrowing and raise more taxes.”
Adding to investor unease, the Institute for Fiscal Studies (IFS) cautioned that the projected revenue from increased national insurance contributions may fall significantly short of the Treasury’s £25 billion estimate. “There are big risks lurking in this budget. Big increases in taxes and borrowing are not costless. Not all of the extra borrowing, by any means, was for investment spending,” wrote IFS director Paul Johnson in a column in The Times. “Most of all, despite all this, I’d be surprised if the spending plans after 2025-26 survive contact with reality,” he continued. “She needs to spend the coming months developing something that looks a lot more like a coherent strategy for the details of tax and spending than we saw this time around.
“I’m afraid this looks like the same silly games playing as we got used to with the last lot. Pencil in implausibly low spending increases for the future in order to make the fiscal arithmetic balance."
"The markets are back policing the chancellor."@SamCoatesSky says Rachel Reeves could find herself "in a bind" after investors had an "adverse reaction" to unexpectedly high levels of borrowing in her budget.#PoliticsHub https://t.co/GlTNasud7Q
— Politics Hub with Sophy Ridge (@SkyPoliticsHub) October 31, 2024
📺 Sky 501 and Freeview 233 pic.twitter.com/k8VW1s0T6z
Further fuelling market tension, figures from the Debt Management Office indicated that debt sales for the current fiscal year are projected to hit £300 billion, exceeding the previous estimate of £278 billion and slightly above what investors had expected. Issuance this year is heading towards being the second highest on record, behind only that in 2020/21 during the COVID-19 pandemic.
The recent increase in gilt yields brings the UK's 10-year borrowing costs close to the 4.63% peak reached after Liz Truss's September 2022 "mini" Budget, which caused significant market turbulence and led to a historic low for the pound.
The OBR highlighted on Wednesday that the scale of additional borrowing had likely caught investors by surprise and would probably push up interest rates over the coming years.
JPMorgan economist Allan Monks also suggested that Labour’s approach to “tax, borrow, and spend on a large scale” could boost both short-term growth and inflation, adding that the Budget “changes the calculus” for potential interest rate cuts.
As a result, swaps markets have adjusted, indicating a slower pace of anticipated rate cuts over the next year, with investors now forecasting three quarter-point rate reductions, down from four or five expected cuts before the Budget’s release.
This shift in interest rate expectations also impacted UK stocks. The FTSE 100 dropped by 0.7%, while the more domestically focused FTSE 250 fell by 1.5%, reversing a previous session gain of 0.5%.
Understanding gilts and their impact on the economy
In recent weeks, terms like “Gilt” and “Yield” have become prominent in financial news, especially after Chancellor Rachel Reeves' recent budget, which has influenced the dynamics of the gilt market.
What is a gilt?
A gilt, or gilt-edged security, is essentially a loan to the UK Government, with the proceeds supporting public spending. Issued by HM Treasury and listed on the London Stock Exchange, gilts hold a reputation for reliability, as the UK Government has always met its repayment obligations. The term "gilt-edged" reflects this trustworthiness, rooted in history since the first gilt was issued in 1694 to finance a war with France. Today, the gilt market is valued at approximately £2.5 trillion, a far cry from the initial £1.2 million raised centuries ago.
This borrowing model isn't unique to the UK; many governments issue similar securities, such as the US Treasury Bonds, Germany’s Bunds, and equivalents from France, Italy, and other countries.
Types of gilts: Conventional and index-linked
The gilt market consists primarily of two types: conventional and index-linked gilts. Conventional gilts make up about 75% of the market. These securities offer a fixed interest payment, called a "coupon," every six months, and are redeemed at a fixed value, typically £100, upon maturity.
Index-linked gilts comprise the remaining 25% of the market and also have a set redemption date. However, their coupon payments and principal values adjust based on the Retail Price Index (RPI), aligning their returns with inflation trends.
Factors influencing gilt prices
Gilt prices fluctuate over time since they are traded securities, and their value can be influenced by multiple factors, including interest rates and government economic policy. When interest rates rise, deposit accounts become more attractive compared to gilts, often lowering demand for existing gilts. Conversely, falling interest rates usually make gilts a more appealing investment.
The maturity timeline of a gilt also impacts its price; as the redemption date approaches, a gilt’s price typically aligns more closely with its original face value. Inflation, which reduces the purchasing power of coupon payments, can further affect demand for gilts.
Calculating gilt yields
Rather than using gilt prices, market participants often discuss gilt yields, as the yield represents the effective cost of borrowing. The “running yield” is calculated by dividing the annual coupon payment by the gilt’s current market price. For example, a 5% gilt priced at £90 would yield 5.55%. When factoring in the redemption price, investors can get a more comprehensive view of potential returns. In the example above, if the £90 gilt is redeemed at £100, an additional capital gain of £10 per gilt would apply.
Effects on corporate bonds
Gilt movements can influence corporate bond markets, as corporate bonds generally trade at a “spread” above gilt yields. This spread accounts for the risk premium investors demand to hold a corporate bond rather than a government-backed gilt, which is considered lower risk.
Why gilt yields matter: Mortgage rates and government finances
The rise in gilt yields has significant implications for both mortgage rates and public finances. Gilt yields directly impact “swap” rates, which financial institutions pay to secure future lending funds. Swap rates, in turn, are influenced by anticipated future interest rates and tend to rise with gilt yields. Consequently, changes in gilt yields can affect mortgage rates, making them a key factor for homeowners approaching the end of a fixed-rate period.
For the government, higher gilt yields mean that additional borrowing must offer higher coupons to attract buyers. This also applies when existing gilts mature, as the government must issue new gilts, potentially at higher rates, increasing its interest payments and straining public finances. Given these pressures, the government has a vested interest in stabilizing gilt yields.
