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Rachel Reeves has succeeded in leading skittish UK bond markets to a safe place. Love or hate the politics of the Budget she delivered this week, it is churlish not to give her credit for that.
Through all the drama on Wednesday, UK government bonds were conspicuously calm. Better than that, in fact, they have pushed higher in price since she spoke, pulling really long-term 30-year yields down close to 5 per cent, and benchmark 10-year yields to 4.4 per cent or so. Sterling is looking quite chipper too, at about $1.32. None of these price gains is large, but the contrast with the disastrous 2022 Conservative “mini”-Budget is obvious and a win’s a win. Markets-wise at least, Reeves has done no harm.
The small puzzle here is what bond investors like so much about the plans she laid out. After all, spending is heading higher. Inflation — bondholders’ kryptonite — is likely to remain sticky, and some of the more painful tax rises do not kick in for a few years. Evidence of a credible growth plan remains scant. But investors are accentuating the positive: Taxes are going up pretty sharply — the kind of rectitude that investors lending to the government like to see. And the chancellor has boosted the buffer against future unpleasant surprises. Ten-year gilt yields now stand only 0.3 percentage points higher than they were when Labour was elected.
“Thus far, for all that she has detractors on both sides of the House of Commons and in the British press, Rachel Reeves has managed to tame the bond market beast pretty well,” said Adam Singleton at the hedge fund group Man.
It is worth pausing for a moment to consider what a fiendishly tricky task that is. Government debt levels everywhere, not just in the UK, have shot up since the financial crisis of 2008, reaching postwar highs in most developed economies. Most likely, they will keep rising too, because of a mix of demographics and higher government spending needs relating to green energy and defence. Politics do not allow for serious cutbacks in spending on social safety nets, as Reeves knows all too well. All told, then, bond investors are being asked to cram down unprecedented amounts of debt.
Meanwhile, as the Bank for International Settlements has stressed, the underlying structure of bond markets has changed enormously. Banks have taken a back seat since 2008, and more recently, central banks have stopped buying, or even started selling, the bonds they bought in stimulus measures both after 2008 and after the 2020 Covid crisis.
Hedge funds and other investment firms have done a lot of work in filling the void, as BIS general manager Pablo Hernández de Cos said in a speech in London this week. For the hedge funds, that often involves using leverage to tease returns out of tiny discrepancies in the geekier corners of the market. This was not always a bad thing, as the BIS noted. But, Hernández de Cos said: “The growing intermediation of record-high public debt levels by non-bank financial institutions introduces significant new financial stability challenges.”
What this means is that, sure, bond markets respond to cold hard economics and fiscal sustainability metrics. But they also reflect the financial constraints on market participants that regulators struggle to observe or control, which can “precipitate stress in financial markets well before theoretical limits of sustainability are reached”.
Hedge fund managers tell me that as the previously dominant, price-insensitive buyers in the pensions sector are melting away, in part because of demographics, some of the really long-term parts of the UK government bond market are now in essence speculative playgrounds. Again, we should all be glad on some level that these rather racy investors are willing to buy gilts, but we should also be mindful that they can and do switch direction very quickly, generating dizzying market gyrations in the process.
To her credit, Reeves this week picked a path through this minefield without detonating anything nasty.
She did, however, also enjoy a dose of that rarest and most valuable commodity: luck. This came with an indirect helping hand from, of all people, Donald Trump. Bear with me.
The president’s loyal Treasury secretary Scott Bessent has made it a key mission to keep the benchmark 10-year US government bond yield under control and down close to 4 per cent, as a way to keep borrowing costs low. That is precisely where it stands today, and investors tell me they are pretty confident he will succeed in keeping it around there in the coming months. This acts as a gravitational force on government bonds all over the world and helps keep volatility low.
Who can say what those flighty hedge funds hacking away in gilts would have done in a more volatile global market environment? Happily, Reeves did not need to find out.
It is easy to see what could go wrong here, jacking up the UK’s already painful borrowing costs — as Reeves said on Wednesday, already £1 in every £10 the government spends is on debt interest. A turn in the global mood could still be painful, especially given the greater influence of speculative investors in the market. For now, though, enjoy the silence.