- Starmer and Reeves’ tax increases have curried favour with bond vigilantes
- Government markets fear a move to the left, as more government spending means a higher supply of gilts
- UK already has the highest 10-year bond yields in the G7 and pays more to borrow than Portugal, Ireland, Italy, Greece, or Spain
- Higher gilt yields will feed into the real economy via mortgages, credit cards and auto loans very quickly
- The UK’s long-dated debt maturity profile offers it some near-term protection
“It remains to be seen whether Sir Keir Starmer leads the Labour Party into the next general election as prime minister, and whether Rachel Reeves keeps her post as chancellor should he fall from office. But whoever is in charge will be confronted by the national sovereign debt and associated interest bill, both of which may limit their room for political and economic manoeuvre,” says AJ Bell investment director Russ Mould.
“No politician will like this, but the UK has the highest borrowing costs of any G7 nation, based on prevailing benchmark 10-year government bond yields, and any new leadership team will have to provide a coherent plan for spending, taxes, and growth to avoid adding to the interest bill.
“Despite the austerity of the Cameron-Osborne years, the national debt continued to grow both in absolute terms and as a percentage of GDP, as the UK spent more than it earned in taxation and borrowing grew faster than the economy overall. Emergency measures during Covid-19, and then over £50 billion of spending to cushion the nation against the after-effects of the energy price shock that followed Russia’s invasion of Ukraine added to the burden. Rachel Reeves has since sought to manage that burden with hefty tax increases across her first two Budgets.
Source: Office for National Statistics
“The extra government income now more or less covers spending, at least until the interest bill on the debt is taken into account.
“The Bank of England had to raise interest rates from their record lows once inflation started to motor after Covid-19, lockdowns and the war in Ukraine, and that added to interest costs, thanks to index-linked gilts and also how the government had to issue gilts with higher coupons to replace those on lower ones as they matured.
Source: Office for National Statistics
“Rachel Reeves is seeking to foster the economic growth that will help render the debt and the interest bill more manageable. Faster growth should, after all, generate more taxes, but there remains a risk that the higher levies already introduced could help raise income but also hinder growth, to leave the nation no better off.
“The chancellor will also be aware there is little appetite for austerity among her backbenchers or across the nation, so any incumbent of 11 Downing Street finds themselves trapped between the bond market on one hand and the ballot box on the other.
“The British public seems keen on having Scandinavian-style welfare support but only funding it with a US-style tax base. To compound their frustration, the percentage of UK GDP that goes on taxes is at its highest levels since 1950, yet no-one seems satisfied with public services, the state of its infrastructure or its ability to defend itself all the same.
Source: Office for National Statistics
“The UK’s awful record of disposing of its prime ministers and chancellors with abandon; its heavy reliance upon imports of vital commodities and raw materials such as food and energy; poor track record on inflation (a perception that owes much to the 1970s’ oil price shocks, as well as failed price, wage and rent freeze policies); and struggles to find funding for the proposed 10-year Defence Investment Plan on top of everything else all mean the bond markets are treating the UK with a degree of caution when it comes to lending us money.
“The UK will not default on its debt, as it has not done so since 1672 and King Charles II’s Stop of Exchequer. But the UK comes with interest rate risk and inflation risk, while some bondholders may look nervously back to 2022’s gilt market ructions and wonder about liquidity risk, even if the liability-driven investment (LDI) crisis was probably a bit of a one-off event.
“Inflation, encouraged by lower interest rates and weakness in the pound, may yet be the only way out of the UK’s debt tangle over time. Price rises thanks to the cost of energy and oil, and their second-round effects through fertiliser, food and other sources, could yet be a problem but the UK jobs market is softening and that may permit the Bank of England to act.
“How gilt markets respond to rate cuts when inflation is above target remains to be seen, but they may not welcome the loss of Starmer or Reeves either, since they have bent over backwards to accommodate bond vigilantes.
“Nor will bond vigilantes want to see any marked move leftward should they survive. More borrowing means more gilt sales and if the supply of gilts goes up then prices are likely to fall and yields rise.
“Using benchmark 10-year government bonds, the UK has the highest cost of borrowing in the G7 at the time of writing.
Source: LSEG Refinitiv data
“It also pays more to borrow for a decade than any of Portugal, Ireland, Italy, Greece, and Spain. This is not a glowing endorsement of the UK’s economic growth, inflation or political outlook and speaks volumes about how those five nations took difficult actions to tackle their own debt problems more than a decade ago and are now reaping the long-term benefits.
Source: LSEG Refinitiv data
“Oddly, gilt yields could fall and prices rally if Starmer and Reeves manage to ride out the storm, or Andy Burnham fails to win the Makerfield by-election in the face of a stiff challenge from Reform’s candidate, Robert Kenyon.
“The 10-year gilt yield was supine in the wake of March’s Spring Statement and even heading lower. It can be argued the Iran war and Labour Party politicking are the reasons for the latest surge in UK borrowing costs, as both serve to aggravate the ultimate issue, which is the size of the national debt and the associated interest bill.
Source: LSEG Refinitiv data
“If there is any good news, it is the lengthy average maturity of UK government debt. Higher gilt yields will feed into mortgage, credit card and car loan costs fairly quickly, as banks will make loans at a premium rate relative to sovereign debt as a reflection of the additional risks, but the government will only take a hit as old bonds mature and new ones are issued with higher coupons.
“The average maturity of the UK government debt is more than 13 years, which is the highest in the G7.”
Source: UK Debt Management Office
