How will the bond markets react to the Budget?
For all the government’s promises of stability and hoped-for reductions in interest rates, UK yields on government bonds are now, in fact, very similar to the levels to which they rose under the ill-fated Truss government, says Paul Ormerod
There has been a huge amount of speculation about the Budget. Later today we will of course know for certain the details of the Chancellor’s widely leaked intention to adjust the government’s public debt targets, allowing for billions of additional borrowing to invest in infrastructure projects.
The reaction of the bond markets is going to be critical to the overall impact of the various measures which Rachel Reeves will announce today.
There is a risk that the package will not be received well by the markets and that interest rates will rise as a result.
In the long build up to the election held in early July, a key theme in Labour’s campaign was that the party would deliver “stability” to the economy. The same message has been repeated many times by both the Chancellor and the Prime Minister in the four months since Labour’s victory.
In one sense there has been stability, but it is not of a kind which is very flattering to the government. The yield on UK government bonds has stayed more or less the same as it was on election day. There was a brief dip with the 10 year bond falling just under four per cent, but it has stayed at four per cent or just above most of the time.
A new government which had the full confidence of the markets might reasonably have expected to see a decent reduction in interest rates. So far, this has not happened. Yields on UK government bonds are now, in fact, very similar to the levels to which they rose under the ill-fated Truss government.
Liz Truss and Kwasi Kwarteng did of course plan very substantial tax cuts, to be financed by additional borrowing.
Tax cuts weren’t Truss’ biggest problem
But, contrary to the general perception, it was not the reductions in tax which created the problems. Their cost was dwarfed by the open-ended commitment to subsidise energy prices which the Truss government made.
An even more drastic reframing of the experience of the Truss government has recently been made by Sushil Wadhwani, a former member of the Bank of England’s Monetary Policy Committee.
In a paper on the VoxEU site – the policy portal for the academic Centre for Economic Policy Research – Wadhwani argues that there are serious misunderstandings of the impact of the September 2022 Kwarteng/Truss budget.
The author finds that once other relevant factors are taken into account, the underlying impact of the higher budget deficit on gilt yields was plausibly less than one-quarter of the actual observed increase in interest rates.
A key point is that from the beginning of August 2022 to 27 September, the day before a major intervention by the Bank of England in the bond market, yields on government bonds rose in several major economies.
In America, the rise on the 10 year yield was 147 basis points (1.47 percentage points) and in Germany 157. True, the UK was more or less double this, at 288 basis points. But the fact that a sharp rise took place in other major economies suggests that a similar increase would have happened in the UK even if the Liz Truss budget had never happened.
Wadhwani has some rather more technical points. But his conclusion is stark. The rise in government borrowing implied in the Kwarteng/Truss budget is responsible for a mere 68 basis points increase in the yield on UK government bonds.
The unpalatable fact for governments is that the long decade after the financial crisis in which borrowing was very cheap is over
The unpalatable fact for governments is that the long decade after the financial crisis in which borrowing was very cheap is over. The repayment of debt incurred now will have a real impact on the ability to spend on public services in the future. The reaction of the markets to today’s budget will be crucial.
Paul Ormerod is an economist at Volterra Partners LLP, a Visiting Professor in the Department of Computer Science at UCL, and author of Against the Grain: Insights of an Economic Contrarian, published by the IEA in conjunction with Morning Wire