No chancellor much likes it when the pound takes a tumble. No chancellor much likes it when the yield on their government debt – the interest rate paid by the state – climbs to historic highs.
When these two things happen on the same day, and in the run-up to a hotly-awaited Budget… well, that’s the last thing any chancellor ever wants to see coming up on their screen. Yet that was the toxic cocktail that awaited Rachel Reeves on the terminal screens in the Treasury on Tuesday morning.
The pound dropped by more than a percent against the US dollar, while the yield on 30-year government debt (known as gilts) rose to the highest level since 1998.
The real question now is: how much does she have to worry about it and, more to the point, what can she do about it?
Let’s start with the first question first. Bond yields are a measure of the interest rate paid on debt and, in the case of government debt, they are influenced by all sorts of things. This makes interpreting their movements quite tricky, at the best of times.
For in one respect, they are a proxy for how creditworthy (or not) investors think a government is. If they think a country is about to default on its debt (Greek bonds and the euro crisis are perhaps the best example) then they might sell a country’s bonds and, lo and behold, the interest rate on those bonds goes up.
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But in another respect they also reflect what people think will happen to inflation and interest rates in the coming years (or, in the case of long-dated bonds like the 30-year gilt, the coming decades). So, if you think inflation is going to be higher for longer, then all else equal, you would expect gilt yields to be higher, since that implies the Bank of England will have to keep its interest rates higher. It all feeds into the government bond yield.
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Nor is that the end of it, because these yields are also affected by all sorts of other things: how much demand is there from pension funds? What’s the impact of the ageing population? How fast is the country going to grow? All of these things (and more) can have a bearing on the bond yield.
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All of which is to say, there’s rarely a single explanation for phenomena like the one we’ve got today. Consider the higher 30-year bond yields faced by the UK. On the one hand, there’s a compelling explanation served up by the Whitehall and parliamentary drama of recent months.
The government has failed to pass some key legislation cutting welfare spending. It has also had to do a U-turn on cutting winter fuel payments. Those two decisions mean it is left with a sizeable hole in the public finances in the coming years. That in turn makes it considerably more likely that it might have to borrow more, which in turn means investors might be getting more worried about Britain’s indebtedness. That’s totally consistent with higher gilt yields. And so perhaps it’s no surprise that the UK’s 30-year bond yield is considerably higher than other G7 nations.
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But it’s not quite that simple. For one thing, Britain is far from the only country in the G7 with a public finances problem. France and the US have deficit trajectories that look considerably less controlled than Britain’s. Nor is it evident from other measures of fiscal concern – for instance, the credit default swaps insuring against a country going bust – that Britain is an outlier.
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Now consider another datapoint: inflation. Britain has the highest inflation rate in the G7, by some margin. In other words, part of the explanation for the UK’s high yields is that markets are fretting not just about fiscal policy (the stuff done in Whitehall) but monetary policy (the stuff done by the Bank of England in the city).
Now, in practice these two worlds bleed into each other. Part (though certainly not all) of the reason inflation is high is those National Insurance hikes introduced by the Labour government.
In short, this is a bit more complicated than some of the more breathless commentary in recent weeks might have you believe. Even so, regardless of how you balance those explanations, there is no doubting that Britain finds itself in a tricky position.
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This combination – of high inflation, weak economic growth and a large and swelling budget deficit – is precisely the economic cocktail that landed the Labour government of the mid-1970s with an IMF bailout. We are a long, long way from anything like that happening this time around. But the ingredients are familiar enough that no one should be altogether complacent.
After all, the last time a government got overly complacent about these factors, back in 2022, we all know what happened next. The mini-Budget, a vertiginous spike in bond yields and a period where Britain’s financial markets stared into the precipice. Best not to repeat that again.
