A spectre is haunting British politics: the bond markets.
Defending Keir Starmer after the disastrous local election results earlier this month, the chancellor, Rachel Reeves, warned that a leadership contest would trigger the wrath of those investors who lend the state money by buying and selling UK government bonds (also known as gilts). The prospect of Andy Burnham winning that contest prompted shriller warnings: the left-leaning contender, after all, had dared to suggest governments should stop “being in hock” to the bond markets.
The bond vigilantes, sober voices tell us, would punish him in the same way they punished Liz Truss’s mini-budget: detecting fiscal irresponsibility, they would sell gilts, thereby increasing government borrowing costs, until he dropped any plans for transformative public investment.
This seems plausible: if you want to borrow, you have to do it on the terms of the creditors who lend it to you. But wholeheartedly accepting this logic turns us into “choiceless democracies”, as the economist Thandika Mkandawire warned, where democratic mandates for change are vetoed by bond investors. Burnham has already this week reasserted his commitment to fiscal rules – a sign of the bond markets’ continued grip on our politics. But there is another way: here is a plan for progressive politicians to stop worrying (too much) about bond vigilantes.
They should start by holding their nerve. Tremors in the bond markets are often driven by global factors. They should also have a clear-eyed understanding of what the bond vigilantes want – and communicate this with the public. The bond vigilantes cheer austerity because their profits are highest when the economy slumps. In this scenario, interest rates are expected to fall and gilt prices increase, pumping returns for investors. Conversely, a mild selloff of gilts often signals that investors expect fiscal plans – that is, government spending – to deliver growth. In other words, good news for the economy is bad news for shifty bond holders.
Since the interests of the public and bond investors are not always aligned, governments have to explore other ways to finance big, transformative ambitions: that means scrutinising the Bank of England, getting rid of inflation-linked bonds, and repurposing Britain’s pension funds.
Let’s start with the Bank of England, which has contributed to Britain’s high borrowing costs and the fear of bond markets. The bank is independent but not neutral: it is run by conservative technocrats protective of the status quo. Following the 2008 crisis, the Bank, like its peers, acknowledged that UK gilts had become the bedrock of our financial system, and announced that it would act as gilt “market maker of last resort”: it would buy them when nobody else would to preserve financial stability. It also embarked on massive “unconventional” gilt purchases – ie, quantitative easing, or QE – during the crisis as it did during the Covid-19 pandemic.
By September 2022, having become the biggest gilt owner, the Bank announced active quantitative tightening, or QT, to deal with inflationary pressure from the war in Ukraine, a policy of selling gilts. But when bond investors repeatedly warned that active QT would increase government borrowing costs, the Bank stopped consulting them. It also ignored other large central banks, which didn’t opt for such an aggressive approach, instead keeping government bonds until they matured.
Since 2022, the Bank has sold £134bn in gilts, with its share of UK gilt holdings nearly halved in three years. This year alone it sold £7.6bn, with another £12bn planned. Investors calculate that active QT has added up to 0.7 percentage points to UK borrowing costs. Think of this as the “Bailey premium”, to recognise the role that the Bank and its governor, Andrew Bailey, have played in the gilt market. Without this premium, the UK government would borrow at cheaper rates than the US.
In many ways the current impasse between central bank and government is the result of the aftermath of Trussgate. Her mini-budget amplified an existing problem in UK pension funds that had made gilt bets with borrowed money. When this dangerous combination threatened financial stability, the Bank offered only two weeks of capped support. But it knew from the eurozone sovereign debt crisis that such half-hearted interventions do not calm markets; in that pivotal moment, the Bank of England walked away from its commitment to backstop gilts.
When Liz Truss resigned a few protesting voices charged the Bank with ousting her government. But the Bank appears to have calculated, correctly, that a British commentariat unfamiliar with the intricate life of gilts would be likely to point to bond vigilantes disciplining the then prime minister, rather than its own decisions. This has had the effect of inflating the bond vigilantes’ power in the eyes of the public. Separately, the Bank also presides over another budgetary timebomb, hidden in the design of its QE programme. Since 2022, it has passed more than £100bn in losses on its gilt holdings to the UK Treasury, with more to come. Again, this is not the policy of other large central banks, which keep losses on their books.
Further increasing costs for the national purse are inflation-linked gilts. Also known as “linkers”, they force the UK government to compensate bond investors for higher inflation. Consider the irony: when the Bank misses inflation targets, the government pays. Britain is uniquely vulnerable, with about a quarter of its bonds inflation-pegged, more than twice as many as Italy or France. Since the 2022 Russia price shocks, the British government has had to pay a staggering £153bn in additional debt service. A progressive government must enlist the Bank of England in an orderly exit from linkers, under a new framework for monetary-fiscal coordination.
Finally, there is the role of pension funds. Back in 2012, the Conservative-Liberal Democrat coalition imposed automatic enrolment in defined contribution pension schemes, in which workers bear the investment risks. These kinds of pension funds prefer to invest in high-yielding stocks and private equity funds rather than less lucrative government bonds. .
As a result, the Office for Budget Responsibility estimates that pension funds will halve their gilt holdings over the next decade, which would eventually result in an increase in annual debt interest costs of about £22bn. This is a political choice that can be reversed. A progressive government could use the recent Pension Schemes Act 2026, which gives governments power to mandate pension fund investments in the UK economy, to channel our savings towards financing public ownership of essential services such as housing, water and transport.
It is clear that if the UK wants transformative change, it needs a new and democratic model of central banking that weakens the power of bond vigilantes. Making the Bank of England serve the common good again, undoing the borrowing mistakes of the past, channelling workers’ capital into public essentials – these are hard political choices, but they exist. Changing the status quo of managed British decline was never going to be easy.