Rachel Reeves should not appease bond market vigilantes

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is an FT contributing editor

Gilts yields have risen over the past month, pushing down prices. Some political commentators have ascribed causation directly to fears of a supply glut in the upcoming Budget. To market professionals, such analysis looks overblown.

As Rob Wood, chief UK economist at Pantheon Economics, explains, gilts have tracked US Treasuries weaker on the back of stronger economic data. This has caused investors to row back their expectations around the pace of interest rate cuts by both the Bank of England and the US Federal Reserve, pushing bond yields higher and prices lower. Supply fears have not been the market’s main driver.

Still, the trauma of Liz Truss’s disastrous “mini” Budget is fresh enough to prompt anxiety among officials about whether the gilt market has capacity to absorb fresh waves of supply. It’s worth recalling how different the economic and financial context is today to that ahead of the “mini” Budget.

Two years ago, every major central bank in the world was raising interest rates to fight spiralling prices. Unveiling the largest package of unfunded tax cuts for half a century looked like adding ideological fiscal fuel to the inflationary fire. And bypassing institutional checks and balances did not help. In response, interest rate expectations reset higher, pushing bond prices down. Doing this when British pension funds were acutely susceptible to margin calls on their leveraged bond positions was pure recklessness. It set off a chain reaction of forced selling and caused financial market chaos. Calm returned only after a central bank rescue, a screeching fiscal U-turn and ultimately a change in government.

Today, the context is less febrile. Inflation is declining, central banks are easing and pension fund leverage has been defanged.

However, bond investors and fiscal conservatives are now invoking the memory of Truss to urge fiscal restraint. There’s a case for ignoring this as special pleading. Government bonds of developed markets like the UK or US that issue their own currency record their strongest returns when the economy slumps. Austerity is always at the top of bondholders’ professional wish lists, and bond investors are frenemies at best to a pro-growth chancellor. Putting too much weight on those investors’ opinion would consign the economy to a tepid growth trajectory.

George Osborne defended his austerity programme in parliament as necessary medicine to retain access to bond markets. This was shortly after Bill Gross — then the world’s most famous bond investor — warned that gilts were “resting on a bed of nitroglycerine”. What followed was a lost decade for economic growth. Public sector investment was cut by a quarter in real terms, and day-to-day spending for non-protected departments plummeted. Both economic productivity and living standards near-flatlined.

But bond investors cheered. Ten-year gilt yields declined from more than 4 per cent to less than 1 per cent over the course of Osborne’s tenure as chancellor — pushing prices substantially higher and generating handsome returns for investors. True, government yields declined across core developed markets. But gilt yields fell more than their counterparts in Germany, Japan or the US as the market discounted semi-permanent stagnation, and the Bank of England was moved to buy bonds to support the economy.

It now looks almost certain that the country’s faulty fiscal rules will be tweaked — perhaps substantially. Doing so will create somewhere between £7bn and £60bn of fiscal headroom depending on the new measure, giving the chancellor greater capacity to fulfil her pledge to “invest, invest, invest”.

Such plans will never be welcomed by the bond market. This is partly because more public investment is likely to mean a greater supply of gilts. But it is mostly because more investment will boost economic growth. This is anathema to bond investors. Paradoxically, such an acceleration is exactly what Britain needs if it is to move on to the path to long-term fiscal sustainability — a cause that they like to champion.

Absent a wholesale demolition of public services, the Office for Budget Responsibility projects the ratio of debt to GDP to double over the next 40 years. But they estimate that every 0.1 per cent increase in productivity growth reduces the long-term rise in the debt-to-GDP ratio by 25 percentage points.

The greatest risk to long-term fiscal sustainability is low growth. And so the greatest compliment the bond market can give a chancellor aiming for economic rejuvenation is a mild sell-off.