Bond Market Risks Heightened by Heavy Borrowing Concerns in Reeves Budget

Government bond investors are likely to be cautious regarding Rachel Reeves’ upcoming budget, particularly if they perceive excessive borrowing, according to insights from a leading City economist associated with the Institute for Fiscal Studies.

Ben Nabarro, the chief UK economist at Citibank who collaborated with the IFS on evaluating Reeves’ fiscal strategies, noted a notable unease among gilt investors in the lead-up to the budget announcement.

He remarked on the lingering implications of the disastrous mini-budget issued two years prior, which caused significant declines in gilt prices and resulted in the Bank of England stepping in to stabilize the situation, ultimately leading to Liz Truss’s resignation as prime minister. Nabarro stated, “International investors are not inclined to give the government the benefit of the doubt.”

Although he initially highlighted a potential “buyers’ strike” among gilt investors, he later softened that assertion while emphasizing the need for the UK to proceed cautiously.

Recent weeks have seen gilt investors displaying increased anxiety, reflected in a rise of 0.32 percentage points in the yield on ten-year government bonds, now at 4.18 percent, despite a growing consensus for potential interest rate reductions. Furthermore, the disparity between UK and German bond yields has reached the widest margin in over a year, coinciding with a decline in the pound’s value from a September peak of $1.34 to approximately $1.31.

The surge in bond yields followed Kwasi Kwarteng’s announcement of unfunded tax cuts in September 2022, resulting in a significant crisis as pension funds worked to unwind complex hedging strategies, creating a cycle of selling pressure. Nabarro believes the current gilt market is “more resilient to those risks.”

Since then, pension funds have decreased their leverage, lowering the likelihood of a recurrence of such issues. Still, Nabarro cautioned that the UK remains more susceptible compared to countries like Japan or members of the eurozone, which have strong domestic demand for government bonds and lesser dependence on international investors.

Nabarro warned that any attempt to excessively stimulate demand in the budget might backfire if it results in increased inflation and rising interest rate forecasts. He suggested that additional borrowing to finance necessary investments should be implemented “gradually.”

This advisory comes as the IFS characterized Reeves’ position as “unenviable,” indicating that she may need to identify around £25 billion in supplementary annual tax revenues by the fiscal year 2028-29 in order to boost funding for vulnerable sectors like education and justice.

The Treasury responded by asserting that the budget would prioritize economic stability through sound fiscal principles, which include balancing current expenditures with revenues and ensuring that the debt-to-GDP ratio decreases over the next five years.

The IFS/Citi report identified another unique vulnerability for the UK: the diminishing demand for long-duration gilts due to the phasing out of traditional benefit pension funds. Additionally, as the Bank of England engages in quantitative tightening by selling off assets, the UK may become increasingly dependent on foreign investors’ support. The report cautioned against relying too heavily on the current goodwill within the gilt market.

Certain pension funds have expressed support for amending fiscal rules to allow for publicly owned assets to counterbalance liabilities in net public sector debt calculations. Notable schemes such as the Universities Superannuation Scheme and the National Employment Savings Trust joined a recent initiative advocating for regulatory changes to facilitate government co-investment in green energy and infrastructure projects.

According to these schemes, “Reforming the fiscal rules to recognize unlisted productive assets will encourage long-term public investment directed towards the net-zero transition, creating opportunities for initiatives like a National Wealth Fund and Great British Energy to attract substantial pension capital.”