Rachel Reeves has ended up with a smaller economy than would have been the case under the Tories – Eddie Mulholland
It is a near certain bet that Sir Keir Starmer will try to defy the bond vigilantes, hoping that global wealth funds will spot a bargain and start scooping up gilts at distressed prices without any need for Labour to change its current destructive course.
He may be lucky, but the international credibility of this Government is already shot below the water line. A few more days like this week’s rolling debacle will force his hand.
“Financial players think they were taken for a ride by Rachel Reeves in her pre-election charm offensives, and they don’t like it,” said Bernard Connolly, a veteran adviser to hedge funds and central banks, through multiple debt crises.
“Treasury reassurances will not help. The real fear in markets is that there is a vicious circle in which low growth worsens debt problems. They increasingly fear that the Government can’t get a grip. Something needs to happen to change the narrative,” he said.
Feeding Rachel Reeves to the sharks might placate some, but it “might also make them smell blood in the water”, he said. The larger fundamental problem remains.
“This Government seems hell bent on snatching defeat from every opportunity,” said Marc Ostwald, a bond specialist at ADM. “We were all hoping for stability after the incessant turmoil of the Tories, but it is now clear to markets that Labour don’t know what they are doing.”
The yield on 10-year gilts briefly touched 4.98pc on Thursday, nearing levels last seen in the late 1990s. “Once it slices through the psychological line of 5pc in a situation like this, the next stop can easily be 6pc. We’re not far away from the point when the Bank of England or the Treasury will have to come up with a circuit-breaker,” said Mr Ostwald.
It is no longer credible to argue that the UK is an innocent collateral casualty of the Trump effect and surging US Treasury yields. This country has carelessly exposed itself as the weakest link in the G7 at a perilous moment, just as international capital markets start to choke on the volumes of debt issuance across the world.
The UK has managed to make an even bigger mess of its fiscal reputation even than Emmanuel Macron’s France, which has no real government, no budget, worse debts and runaway fiscal deficits of 6pc of GDP. This is quite a feat.
The former “PIGS” of the eurozone debt crisis – Portugal, Italy, Greece and Spain – have all done better. Italy’s 10-year bond yields are today slightly lower than they were a year ago. They were then trading at the same level as equivalent gilts. As I write, Reeves must pay 130 basis points more than her Italian counterpart to borrow for 10 years.
“That tells you more than anything else what an absolute mess we have got ourselves into, and I don’t see how Labour can easily turn this around,” said Albert Edwards, global strategist for Société Générale.
We cannot keep fooling ourselves that higher borrowing costs chiefly reflect a perkier economy, with less risk of recessionary deflation than the becalmed eurozone. That comforting illusion died when Reeves talked the economy into zero growth with her mischievous black hole.
She kicked business in the teeth and concocted a Budget plan that borrows an extra £142bn over this parliament – and still ends up with a smaller economy and lower real living standards than would have been the case under Rishi Sunak.
It has taken just three months for the Chancellor to lift the toxic “term premium” on British bonds to levels that endanger this country’s long-term debt dynamics.
The widening gilt spread over Italian, French or Spanish bonds is doubly remarkable because the UK has what ought to be an advantage. The Bank of England can intervene at any moment to buy debt and burn speculators.
The European Central Bank is more constrained by the “no bailout” clause of the Maastricht Treaty. It can no longer get away with monetising the debts of southern Europe under the guise of quantitative easing, and it does not have the legal or political power to do so with its new anti-spread tool (TPI) except in extremis.
Yet traders are still betting more heavily against Reeves regardless.
Krishna Guha and Marco Casiraghi, from Evercore ISI, said the gilts sell-off has not yet reached “Liz Truss standards of crazy” but it is becoming serious enough to require an emergency response.
“We think the Bank of England should consider suspending quantitative tightening (reverse QE) if market pressures continue to build over the next few days, with more radical steps to buy gilts outright,” they said.
They warned that it is a dangerous time for sovereign borrowers to court fate because bond dealers everywhere are holding lower inventories than they used to, starving the market of liquidity and inviting spasms of debt stress.
Whether or not the Chancellor meets her fiscal rule is an entirely trivial question.
Global funds could not care less about this arcane British obsession. They care only whether they are being sufficiently rewarded to accept the credit risk of a country issuing £297bn of Treasury debt this fiscal year, and eye-watering sums thereafter, mostly for purposes that do not raise productivity or the UK’s economic speed limit.
Two thirds of extra borrowing is going on fatter pay for Labour’s friends – only a third is going on public investment, the turbo-charged part with a growth multiplier that pays for itself.
Is the yield high enough for a Japanese, Canadian or Saudi investor to justify the inflation risk, currency risk, and economic risk of funding a nation living beyond its means, with a chronic balance of payments deficit near 4pc of GDP, and a net international investment position of minus £1.05 trillion that is run by a political party with no collective experience of the real economic world?
Mr Connolly has a few words of advice from the world of global Big Money: cut corporation tax and freeze both public sector pay and recruitment. Not that he is expecting any such action. “The underlying situation – public finance, current account, productivity, investment, health service – is dreadful. It’s not Argentina territory but a chainsaw would be useful,” he said.
Labour is now hostage to world forces. Donald Trump and Elon Musk may relieve the pressure by slashing spending and tightening US fiscal policy more than markets expect. The Chinese “carry trade” may keep growing, funnelling more of the world’s trapped savings into global credit. Both effects would bring down bond yields for the rest of us.
But Labour has learnt that the Hobbesian hard-knuckled world of 2025 will not extend an unlimited credit line to a self-indulgent class-warfare party that borrows promiscuously to fund consumption, and does profoundly stupid things such as taxing child education and raising the marginal tax rate on small firms to exorbitant levels.
The sooner that Labour recognises the scale of its misjudgements, the more likely it is to earn a second chance.
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