Britain vs. the Bond Vigilantes

After a decades-long slumber, the bond vigilantes are back

британский фунт стерлингов british money pound
Photo: © Depositphotos/nestik

The British bond market’s reaction to the new Labour government’s first budget underscores the complex challenges policymakers face in balancing large fiscal deficits with rising social, environmental, and geopolitical pressures. The risk that public borrowing could crowd out private-sector investment is both clear and immediate.

Just two years ago, the chaotic rollout of then-Chancellor of the Exchequer Kwasi Kwarteng’s «mini-budget» nearly triggered a meltdown in the government-bond (gilt) market. By contrast, Labour Chancellor Rachel Reeves approached her first budget with extreme caution, as Treasury staff scrutinized proposals, consulted market participants, and sought to anticipate and address every potential risk. The independent Office for Budget Responsibility (OBR) provided an in-depth analysis of the budget’s projected impact on growth, inflation, and public debt. Unlike previous budget announcements, this one involved no high-profile dismissals and featured few policy surprises.

The bond market initially responded positively, with yields declining steadily as Reeves presented Labour’s first budget in 14 years to Parliament. But sentiment shifted quickly once the Debt Management Office revised up its bond-issuance projections and the OBR released a comprehensive 205-page assessment of the growth and inflation implications of the government’s proposals.

While markets are often unpredictable, the bond market’s reaction suggests that the OBR — the independent body with the most comprehensive information — views the government’s budget as essentially a continuation of the status quo. Despite significant tax and spending increases, the budget probably will not improve the country’s growth prospects.

To be sure, the initial surge in spending may lead to a short-term boost in GDP growth. But these gains will likely be short-lived, as higher interest rates crowd out private-sector activity. Moreover, government stimulus in an economy already operating near full capacity and with a tight labor market implies that inflation will exceed the Bank of England’s 2% target over the next few years, auguring an extended period of elevated interest rates.

Although Labour inherited tougher economic conditions than it did the last time it came to power, under Tony Blair in 1997, the key lesson is that the one positive factor — a robust private sector — also limits the government’s ability to meet urgent investment needs.

This dilemma is not unique to the United Kingdom; it affects all developed economies. The fiscal response to the COVID-19 pandemic led to a massive liability transfer from private to public balance sheets — a global economic intervention comparable to the post-World War II Marshall Plan to rebuild Europe. While largely effective, this effort carried significant risks and costs, as demonstrated by the UK’s own attempts to address long-standing issues and preempt emerging threats.

During the pandemic, weak private demand made it easier for markets to absorb the government’s significant funding needs. To reinforce this, central banks effectively subsidized government borrowing through aggressive bond purchases.

Prime Minister Keir Starmer appears to recognize that supply constraints limit his government’s ability to «fix the foundations» of the British economy. The new budget aims to overcome these constraints, but according to the OBR, it is unlikely to deliver tangible results until after the current Parliament ends in five years. Meanwhile, the bond market is threatening to undermine these plans, jeopardizing the benefits of increased public investment.

Bond markets tend to reward fiscal prudence, providing responsible governments with the breathing room needed to adjust their policies following large shocks. For now, this patience extends to the UK because, unlike in 2022, there is little concern that this budget will put the country on an unsustainable debt trajectory.

But the bond market cannot ignore constraints on growth. Eventually, weak growth prospects and tight labor markets will force governments to make a difficult choice: either scale back their agenda, or let the private sector bear the brunt of higher interest rates. This challenge is compounded by major central banks’ push to reduce their exposure to sovereign bonds, as balance-sheet reduction is analogous to a reversal of «foreign» capital flows into sovereign-bond markets.

Though rising risk premiums on longer-term government bonds in the UK and the United States are driven by different forces, they reflect the same underlying issue: with limited excess savings, large or growing fiscal deficits come at the cost of crowding out private-sector demand.

The post-Brexit UK offers a glimpse into how US President-elect Donald Trump’s plans to restrict immigration and unwind preferential trade relationships could reverberate through bond markets and weigh on the real economy. Immigration, after all, has been cited as a key factor in sustaining US growth rates well above potential over the past year.

No matter how prudent their fiscal policies, governments today must come to terms with the realities of deeply interconnected sovereign-bond markets. The actions of the largest borrower, the US, directly affect most countries’ borrowing costs. This is especially true for countries like the UK, which rely on the kindness of foreign bond investors to finance their debts.

Gene Frieda, a former global strategist at PIMCO, is a senior visiting fellow at the London School of Economics.

© Project Syndicate 1995-2024

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