UK: Bond vigilantes looming

Beware the bond market

In the realm of financial markets, bond investors wield significant power, often acting as a check on government fiscal policies. This phenomenon, famously termed ‘bond vigilantes’ by U.S. economist Ed Yardeni in the 1980s, underscores the influential role of bond markets in maintaining economic discipline.

When governments engage in fiscal practices perceived as reckless, such as excessive borrowing or unchecked spending, bond investors may respond by demanding higher bond yields to offset the increased risk. This reaction raises the cost of borrowing for the government, effectively pressuring policymakers to adopt more prudent fiscal measures. The concept of bond vigilantes highlights the interconnectedness of financial markets and government actions.

Bond vigilantes return to the House of Commons

Bond vigilantes, much like uninvited guests at a dinner party, show up from time to time, refusing to leave until the party is well and truly over. In Brazil, sovereign debt yields have recently traded north of 15 percent, reflecting investor concerns over its fiscal stability under President Lula’s administration. The Brazilian real currency has depreciated by almost twenty percent versus the US Dollar since the beginning of 2024.

The phenomenon is not confined to emerging market economies. Developed nations, too, can face similar scrutiny when fiscal policies are deemed unsustainable. During the European sovereign debt crisis, countries such as Ireland, Greece, Portugal, Italy and Spain came under intense scrutiny due to their high levels of public debt. Similarly, the UK’s "mini-budget" in 2022 triggered substantial market volatility.

Today the vigilantes are once again knocking at the door of the UK House of Commons.

A repeat of the notorious 'mini-budget'?

Replacing Boris Johnson as UK Prime Minister on the 6th of September 2022, Liz Truss served as the UK’s leader for forty-five days before she resigned, making her the shortest-serving Prime Minister in UK history.

Ignoring the Office for Budget Responsibility (OBR), Chancellor Kwasi Kwarteng delivered the now notorious "mini-budget" which included £45 billion of unfunded tax cuts. This led to a sharp rise in UK government borrowing costs, with 10-year gilt yields increasing by approximately 1.4% in just one week. Sterling fell to US$1.035 versus the US Dollar, its lowest level since 1985.

The Bank of England (BoE) was forced to come to the rescue, purchasing close to £20 billion of UK government bonds. The bond purchases ironically took place at a time when the BoE had planned to commence a quantitative tightening program by selling UK government bonds. This intervention stabilised the bond market and prevented the collapse of UK pension funds.

The level of panic and market reaction in the recent UK episode has been less severe compared to the 2022 crisis.

UK faces challenges

The recent market stress in the UK has indeed seen a more measured increase in gilt yields, with the 10-year yield rising by about 1.1% over four months. This is relatively moderate, especially considering the concurrent rise in bond yields across major countries.

Current UK Chancellor Rachel Reeves has taken a more prudent approach by involving the OBR in the recent budget process. This contrasts with the previous administration’s approach in 2022 and reflects a commitment to fiscal responsibility and market stability.

The UK is currently grappling with several significant challenges. Economic growth is slowing down at a time when government borrowing costs remain elevated, amid persistent inflation. UK economic growth initially rebounded in the first half of 2024, with gross domestic product (GDP) increasing by +0.7% and +0.4% in the first and second quarter respectively. Recent monthly GDP data have disappointed, however, casting doubt over the OBR’s two percent growth forecast for 2025. There has been an alarming number of headlines suggesting that the UK economy is on the brink of stagflation (stagnant economic growth coupled with elevated inflation).

Lower interest rates in the UK would indeed offer dual benefits – supporting a weaker economy and reducing government borrowing costs. However, the BoE faces constraints due to persistent inflationary pressures, which limit the pace at which it can cut rates. Recent Purchasing Manager Index (PMI) surveys highlighted that cost inflation reached an eight-month high. Additionally, a survey from the British Chamber of Commerce revealed that over fifty percent of UK companies plan to increase prices in the coming months.

Figure 1: US, UK, German 10-year bond yield, %

Source: Bloomberg, 20th January 2025

What next for the UK government?

Given the more muted levels of market stress compared to the 2022 episode, it is unlikely that the BoE will intervene with bond purchases for now. The Bank’s next monetary policy meeting takes place in early February. Market participants will closely monitor the narrative and guidance provided to gauge the committee’s level of concern about inflation risks and their willingness to implement interest rate cuts in the coming months.

The UK government is currently prioritising communication to boost confidence levels, with an emphasis on growth. Chancellor Reeves has emphasised to members of parliament the need for the UK to go “’further and faster’ to achieve economic growth. A summer spending review is due in June, although the new Labour government will be reluctant to renege on its own promise not to raise taxes further or to take the unpopular step of cutting public spending.

The government will be hoping for signs of easing inflation, a decline in global bond yields, or improvement in UK economic data to alleviate the pressure on Chancellor Reeves.

Sterling outlook

Sterling currency has weakened against the US Dollar from around US$1.34 last September, prior to the UK budget announcement, to ~US$1.23 today (21st Jan 2025). Current spot levels are still well above the lows of ~US$1.04 reached during 2022.

Previously, higher UK gilt yields have tended to support Sterling, especially against the Euro, as markets anticipated more aggressive rate cuts from the European Central Bank (ECB) compared to the more gradual approach of the BoE.

Recently, the 10-year UK gilt yield reached its highest level since 2008. However, this time, Sterling hasn’t benefited from the rising yields. The focus has shifted to the negative impact of higher yields on the UK government’s future debt servicing costs amid deteriorating economic growth.

If inflation pressures ease, allowing the BoE to implement more rate cuts than anticipated, it would be a welcomed relief for the UK government. However, this scenario could also make Sterling vulnerable to both increases and decreases in gilt yields. We remain cautious on the near-medium term outlook for sterling versus both the US Dollar and the Euro.

Figure 2: GBPUSD 5-year spot price

Source: Bloomberg, 20th January 2025.