Will Rachel Reeves resign if she misses her fiscal targets? No, she said on Times Radio on Thursday, because she won’t miss her fiscal targets. It would not be allowed to happen.
Why not? “If you don’t meet your fiscal rules, if you lose control of the public finances, then what happens is what happened when Liz Truss was prime minister. I will never repeat those mistakes, because when you lose control interest rates rise, prices soar, and in the end the costs fall on families and the whole economy.”
In other words, nothing is more important than preventing another gilts crisis, the rapid rise in government borrowing costs that did for both Truss and her chancellor Kwasi Kwarteng two and half years ago. This truth has been hiding in plain sight for a while but Reeves has now pulled the cover off so all can see. This government’s policy is being driven not by manifesto commitments, campaign promises or cabinet discussion but by bond investors.
Were the cuts to welfare payments announced last week about “unleashing the talents of the British people”, as the work and pensions secretary Liz Kendall told the House, or were they the result of a search for a quick set of savings that would do the bookkeeping necessary to meet the fiscal target?
Almost certainly the latter, particularly as the cuts were tweaked at the last minute to allow the numbers to add up perfectly. There was a £9.93 billion margin against the main fiscal rule at the budget in November, and exactly the same this week. Is Reeves overstating the risks of another mini-budget drama? Are conditions the same as they were in September 2022?
Truss and Kwarteng were undone, in the end, by their ignorance of a fundamental change in financial markets. Bond investors around the world were jittery owing to the return of inflation and with it rapidly rising central bank rates.
Inflation and rising rates are kryptonite to bond returns; if you are buying a fixed income, nothing kills your profits faster. The bond markets had not had to worry much about either for the previous two decades but everything was changing, and fast.
In the eight months before Truss’s arrival in No 10, consumer price inflation went from 6 per cent to 11 per cent (and 0.4 per cent to 6 per cent in the previous year) and the base rate from 1.75 per cent to 5.25 per cent. That left pension funds, which had bought protection against interest rates going lower, not higher, in an exposed position.
When the mini-budget came out with inflationary (and uncosted) tax cuts and the hearty promise of more to come, all without any judgment from the Office for Budget Responsibility, bond investors took fright. The sell-off turned into a rout because pension funds looking to raise money had to dump their gilt holdings quickly. Gilt yields had their single biggest daily rise since 1985, and sterling fell to its lowest level against the dollar since the 1970s.
Now, however, inflation is coming down, as are central bank rates. There does not appear to be another pension sell-off-style bomb waiting to go off — although, interestingly, the US financial think-tank the Brookings Institution last week warned of leveraged bets by hedge funds against sovereign bonds. Reeves, you might think, should be able to act without fear of the bond vigilantes riding into town.
There is, however, evidence that she is right to be fearful. Gilt yields have not shot up in the way they did after Truss’s best efforts, but they are still high and, crucially, are much higher than those in rival European countries. The yield on the ten-year gilt is 4.7 per cent. The ten-year bund, the German equivalent, yields 2.7 per cent. In France it is 3.4 per cent, Spain 3.3 per cent, Italy 3.8 per cent and Greece 3.5 per cent.
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Investors obviously see something about the UK that makes them demand a higher rate for lending it money. Two somethings, in fact: a conviction that inflation may stay higher for longer here than elsewhere; and an uneasiness about the total level of government debt (100 per cent of GDP), and how much more will be issued this year (about £300 billion).
This uneasiness flared up briefly when Reeves delivered the spring statement, when the ten-year gilt yield jumped to 4.8 per cent before settling back down.
“This level of intraday volatility is sending a strong signal to the government that investors are nervous and need to be convinced about the value and quality of UK gilts,” said Grégoire Pesques, chief investment officer for global fixed income at Amundi, Europe’s largest fund manager.
“Higher inflation and limited fiscal headroom are part of the problem, along with a large fiscal deficit,” said Bill Casey, a fund manager at Schroders.
Given this level of unease, the fiscal rule is one reassurance Reeves can offer. David Miles, one of the three-member committee which runs the OBR, was on Times Radio straight after Reeves, and that was how he put it. “The target is there for a reason. When a government needs to sell as much debt as this one — well, nobody is required to buy it. They will only buy it if it is a good financial deal, if the return is right, given the risks around UK government debt. It is not a fetish, it is a realisation that there has to be some reassurance.”
Also on Times Radio that day was Richard Burgon, Labour MP for Leeds East. He and other MPs were deeply unhappy about the welfare cuts, he said, and threatened a rebellion when they were put to a vote in parliament. Reeves will probably survive a backbench revolt. She might not survive an uprising by bond investors.
