GLOBAL bond investors reminded Prime Minister Keir Starmer of a harsh truth of British politics: The market’s verdict can be swift and punishing.
Starmer’s ruling Labour Party started the day on a face-saving mission after its MPs forced it to scrap £5bil (US$6.8bil) worth of cuts to welfare spending on Tuesday evening – making it even harder for Chancellor of the Exchequer Rachel Reeves to tame the government’s budget deficit.
But instead of rallying behind Reeves, Starmer failed to back her when questioned in Parliament, creating a bizarre scene as a visibly upset chancellor was sitting behind him and appeared to be crying.
The reaction was quick. As speculation of Reeves’ potential ouster raced through markets, 30-year gilt yields surged 19 basis points Wednesday, the biggest jump since April and one strong enough to send ripples into US Treasuries.
Stocks slid. And the pound tumbled as investors headed for the exits, sceptical of Starmer’s continued commitment to shoring up the nation’s precarious finances.
“It takes very little to light the fuse when things are in a bad place,” said Neil Mehta, a portfolio manager at RBC BlueBay Asset Management, on gilts’ vulnerability to sudden slides.
“Markets will be on high alert over the next months.”
The sell-off evoked smaller-scale echoes of the UK’s market crisis in 2022, when Prime Minister Liz Truss was swept from power after her calamitous mini-budget rattled the confidence of investors and sent borrowing costs soaring.
“Should the UK government fail to take the drastic measures to restore market confidence, the gilt curve will continue to steepen and the pound sell off in a Truss-like fashion,” said Luigi Buttiglione, founder of advisory firm LB Macro.
“This would make the government capitulate anyway, as it was the case for Truss, and even for Trump following the infamous ‘Liberation Day’. The market always wins.”
In an apparent bid to calm markets, Starmer eventually gave Reeves his full backing in an interview with the BBC late Wednesday. She would remain as chancellor “for many years to come,” the premier said, hours after failing to guarantee her position when asked in parliament.
Traders had been waiting for a more robust defence of Reeves, concerned Starmer could seek to appease Labour lawmakers by replacing her with a chancellor more willing to hike spending and borrowing.
“The market reaction of the last couple of hours tells the government, and Labour backbenchers, what they need to know,” said Simon French, chief economist at Panmure Liberum.
Bookmakers’ favourite
French said that replacing Reeves with Cabinet Office minister Pat McFadden – the bookmakers’ favourite and a fiscal hawk – or Home Secretary Yvette Cooper – who is a popular choice among Labour MPs – would “perhaps get status quo with markets,” but that “any other combination” would be seen as negative for gilts and the pound.
Even before Tuesday’s drama, the Labour government was already facing doubts over its ability to fund its spending plans – as well as its commitment to self-imposed fiscal rules.
Reeves is facing a growing fiscal hole ahead of her autumn budget, fuelled by the £5bil climbdown on Starmer’s flagship welfare reforms and the £1.25bil reversal on giving winter fuel payments to pensioners.
Potential downgrades
Potential downgrades to Britain’s growth outlook from the Office for Budget Responsibility (OBR), the UK’s fiscal watchdog, also make for a perilous situation.
Those factors – combined with the slim £9.9bil fiscal buffer Reeves left herself at her spring economic update – have led economists to predict the chancellor is on course to hike taxes in the autumn, and could even relax her fiscal rules.
The rise in gilt yields “has shone a light on how sensitive investors have become to news about UK fiscal policy,” Bloomberg Economics chief economist Dan Hanson wrote in a note.
“It appears to be a question of when, not if, taxes will need to rise again.”
Hanson predicts Reeves is facing a £20bil shortfall going into her autumn budget.
Reeves did not repeat her usual insistence on the non-negotiability of Britain’s fiscal rules when questioned in Parliament on Tuesday, but Starmer’s official spokesman Tom Wells told reporters on Wednesday that the UK’s position has not changed.
The government is likely to soften its fiscal rules at the autumn budget if the OBR forecast gets worse instead of better, and there’s “a slightly more than 50-50 chance of this happening,” Tom Pope, deputy chief economist from the Institute for Government, told Bloomberg.
Ahead of its thumping election victory a year ago, the Labour Party promised not to increase Britain’s main taxes on regular people – income tax, national insurance and VAT (a sales levy).
Few options
This leaves Reeves with few options for raising revenue, but she could lift rates on property and pensions or freeze thresholds so that more people pay higher rates of income tax as their wages grow. — Bloomberg
Joe Mayes, Greg Ritchie and Freya Jones write for Bloomberg. The views expressed here are the writers’ own.
