On rising gilt yields. . .
The uptick in UK 10-year gilt yields of c.50bp since mid-September seems to have sparked concern among some commentators that bond markets may be growing apprehensive about overborrowing by Chancellor Rachel Reeves in the upcoming 30 October Budget. It follows her hints that she may increase debt to finance a needed step-up in public investment. Upon closer examination, however, such concerns look exaggerated. For now, the rise in yields can more plausibly be attributed to a host of other mostly global factors.
Over the same period, Brent crude oil prices have risen by around 8% while natural gas prices are up by some 10%. Reacting to the prospect of a modest energy-related inflation uptick, 10-year bond yields have risen across all G7 economies: in the US by c.50bp, in Canada by c.40bp, in France by c.20bp, in Germany by c.15bp, in Japan by c.15bp, and in Italy by c.10bp.
The rise in UK yields is in line with the US uptick but notably higher than in other major Eurozone economies. Is the spread widening versus Europe a concern? Not really, since it has occurred alongside directionally-consistent shifts in consensus expectations. Over the past month, Bloomberg consensus growth forecasts for the UK have been revised up from 1.3% YoY to 1.4% for 2024 while projections for the US have increased from 2.5% to 2.6% for 2024 and from 1.7% to 1.8% for 2025. Consensus expectations for the Eurozone in 2026, meanwhile, have been cut from 1.5% to 1.4% - with 0.1pp downgrades for both 2024 and 2025 for Germany.
The rise in US and UK bond yields is also proportionate to the shifts in relative money market expectations for central bank rates - whereas the Eurozone looks somewhat on the low side. At the three-year horizon, implied money market central bank expectations have risen for the US Federal Reserve (Fed) by c.50bp to 3.4%, for the Bank of England (BoE) by c.50bp to 3.7%, and for the European Central Bank (ECB) by c.40bp to 2.2%.
Although UK inflation expectations have risen little, the increase remains well in line with the energy price effect. UK two-year breakeven inflation rates have risen by around 25bp to 3.2% since mid-September – well below the peak of 4.3% in mid-April. This measure, which is based on the Retail Price Index (RPI), suggests that the market is pricing in a Consumer Price Index (CPI) inflation rate of approximately 2.4% on the two-year horizon - close to the BoE's 2% inflation target.
Naturally, after the scarring experience of the late-2022 UK bond market panic caused by the September 2022 Truss mini-budget, commentators are watching closely for signs of another wobble. But for now, the economic evidence offers little reason to get worked up.
As Figure 1 shows, recent moves in UK gilt yields are well within the two-year range. What really stands out, however, is the steady rise in the Pound Sterling over the past two years – admittedly from an initially low level. But this hits on the critical issue.
As the October 2022 experience showed, bond market panics over fiscal sustainability tend to have two characteristics: 1) rising bond yields; and 2) a weaker currency. At present, we see the opposite. Bond yields have risen to reflect slightly higher expectations for growth, inflation and BoE rates, while sterling has edged up a bit. This is normal. Even if Reeves' borrowing were to push up bond yields, as long as there is no sign of genuine panic, modestly higher borrowing costs on their own should not deter the chancellor.
Of course, a lot can happen between now and the 30 October Budget, and Reeves' policy guidance has been a bit up and down, to put it mildly. Prior to the election, she had campaigned on an optimistic ticket, promising investment-oriented pro-growth policies. After winning power, her tone turned gloomy. Warnings of ‘difficult decisions’ produced a sense of foreboding among businesses and consumers, who feared a fiscal tightening and even a return to austerity. More recently, Reeves has turned more optimistic again.
In the final analysis, none of this changes the difficult fiscal backdrop. With a deficit of 3-4% of GDP and public debt at almost 100%, Reeves has little room to manoeuvre no matter how she tries to frame the economic and fiscal situation.
On fiscal credibility. . .
In the past fifty years, whenever power has changed hands from the Conservatives to Labour or vice versa, chancellors have made a bold change in the fiscal or monetary framework to strengthen their commitment to sustainable policy-making.
- In March 1981, the Conservative Government under Prime Minister Margaret Thatcher introduced the first index-linked gilts - which compensate the bond holder for inflation both on the coupon and the principal on redemption.
- In May 1997, newly elected Chancellor Gordon Brown granted the Bank of England (BoE) operational independence over monetary policy in order to achieve an inflation target set by the government. In 1997 Brown also introduced the UK’s first fiscal rules to constrain government decisions on spending and taxation.
- In May 2010, a newly elected Conservative-Liberal Democrat coalition established the independent Office for Budget Responsibility (OBR). The OBR produces forecasts on the UK economy and public finances, evaluates fiscal policies against government rules and targets and assesses long-run fiscal sustainability.
What could Reeves do to firm up her own credibility? That is hard to say. All of the obvious levers have been pulled by her predecessors. Her decision to strengthen the powers of the OBR back in July has helped, but only at the margin. And I suspect most market participants have forgotten that by now at any rate.
Apparently, she is considering changing the fiscal rules to allow for more borrowing to finance higher public investment over the parliament. Such changes may involve excluding public investment from the deficit target as well as switching the target for debt as a percentage of GDP to some measure of public sector net worth.
While these adjustments better orient fiscal policy towards promoting long-run growth and may create room for extra investment, in the end, they amount to accounting acrobatics. The UK’s fiscal liabilities remain the same however they are counted.
