(Bloomberg) -- A rout in UK bonds has evoked memories of the market crisis during Liz Truss’s calamitous premiership and raised questions over Chancellor of the Exchequer Rachel Reeves’ budget plans.
Economists are warning the Labour government may need to raise taxes or cut spending as a jump in borrowing costs will leave the government with less spare cash to boost investment and fulfill its 2024 election promises.
The crisis in 2022 effectively ended the Truss government, and Labour will be concerned about the market jitters and a worsening economic growth outlook.
What caused the Truss bond crisis?
Bond yields soared and the pound tumbled in response to Truss’s autumn mini-budget, kicking off a crisis that would eventually end her short-lived premiership. Investors were rattled by her plan for £45 billion ($55.4 billion) of unfunded tax cuts at a time when the government was already paying billions of pounds to support households through an energy crisis. Her chancellor, Kwasi Kwarteng, poured fuel on the fire by promising even deeper tax cuts.
The bond collapse was accelerated by so-called liability-driven investment strategies employed by the UK pensions industry. The surge in bond yields forced LDI funds to sell gilts, sending their yields even higher. The Bank of England said around half of the fall in gilt prices was due to LDI selling. The central bank swooped in with government debt purchases to restore calm.
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Is it happening all over again?
The latest market moves have been less extreme. The government isn’t fanning the flames in the way Kwarteng did. Ministers have been largely quiet, government policy hasn’t changed in recent weeks and the Treasury has reiterated its commitment to prudent fiscal policy. There is no sign of any lurking vulnerabilities in the market this time around.
The gilt market appears to be more resilient than it was in 2022. Pension funds using LDI strategies must now hold larger cash buffers in order to reduce the chance of another liquidity crisis. The BOE is also developing a so-called repo facility which will allow these funds to raise cash in the event of future turbulence, alongside its existing lending operations for banks.
The market moves are still a headache for the government. Bond yields have risen steadily since Reeves unveiled plans to increase spending and borrowing at her first budget at the end of October. However, the watchdog — which was sidelined by Truss — said in October it expected Reeves to meet her self-imposed fiscal rules: that the government will only borrow to invest and will have a measure know as “net financial debt” falling by 2029/30.
What does it mean for the government?
Economists said the surge in bond yields wipes out the already narrow headroom Reeves left herself at the autumn budget, leaving the government’s spending plans up in the air.
Her budget was also underpinned by growth forecasts from the OBR that are more optimistic than those of the BOE and private-sector economists.
Even small downgrades to the OBR’s view of the UK’s longer-term growth prospects would mean Reeves would need to return with spending cuts or tax rises to fill a black hole. Growth has stalled since Labour took office in July, and investors’ faith in Prime Minister Keir Starmer’s pledge to turbo-charge the economy may be waning.
Reeves will be looking to hold her nerve until the OBR gives its next verdict on March 26. At that point she can decide whether to cut spending or raise taxes if the OBR tells her she would otherwise break her fiscal rules. If the market turmoil continues, she may look to restore calm by signaling fiscal adjustments to come.
Some economists have questioned whether any spending cuts that might be penciled in by the government to plug the new hole would be credible.
Why are investors concerned about the UK’s finances?
Longer-term bond yields have been rising in other major economies in January, without causing the same unease as in the UK. Where usually higher bond yields would support a nation’s currency, the pound has dropped to more than a one-year low.
While the UK isn’t the only country pursuing a more expansionary fiscal policy, its recent track record on state borrowing means traders may be taking a dimmer view of UK assets than those of other developed economies.
The UK’s appeal as an investment destination has been dented by Brexit and years of political instability that came to a head with the Truss crisis. Britain is also suffering a confluence of misfortunes, with low growth, high debt and sticky inflation.
The OBR has warned the UK public finances are more vulnerable than other advanced economies on several fronts. A lot of Britain’s debt is held by foreign investors and the country often runs a current account deficit, making it more vulnerable to sudden shifts in market sentiment.
Might the BOE intervene again to calm the market?
The BOE may be reluctant to weigh in and buy gilts as it’s been reducing its holdings of government bonds as part of a process known as quantitative tightening. This has increased the supply of gilts, adding upward pressure on yields, but the BOE is unlikely to change tack. Only £13 billion of the current year’s £100 billion reduction in the BOE balance sheet comes from active sales. The rest is from notes that were due to expire, so it’s not clear that any change in QT would make much difference.
If there are signs of a disorderly market drop, with excessive volatility in prices, the BOE may turn to some tools it used in recent crises to boost market liquidity.
--With assistance from Greg Ritchie.
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