Why Westminster is wrong about gilt yields

It’s gilts season at Westminster. This is one of those unpredictable events, like the passing of a comet, that sees the residents of the political village staring at the skies and imputing all sorts of divine causes to the curious flashing lights they see there.  

Because of the ongoing excitement in the markets, a lot of political folk have, in the last few days, become authoritative commentators on yield curves.

Welcome to the party, guys. A very long time ago, I covered bond markets for a City newswire, and hated pretty much every minute of it. I claim no particular expertise as a result, but I am still confident in saying two things about Westminster’s current excitement over gilt yields.

First, almost no one involved in or commenting on British politics (I include myself) knows enough about bonds to offer a wholly credible analysis of any particular market movement.

Second, and consequently, anyone who asserts that rising gilt yields are entirely caused of Rachel Reeves and her Budget should be ignored because they a) don’t know what they’re talking about b) are pushing a political agenda c) both of the above.

This is especially true of anyone who argues that current bond market movements are similar to those following Liz Truss’s mini-Budget debacle.

The central flaw of much Westminster bond market analysis (and much else besides) is to explain everything by reference to short-term UK politics, and overlook bigger things happening elsewhere.

So anyone who wants to argue that Reeves’ tax-raising Budget spooked the bond markets should be asked: why have UK gilt yields have moved pretty much exactly in line with US Treasury yields?  In other words, the same investors who are selling gilts are also selling US bonds – and selling US bonds is clearly not a comment on British fiscal policies or Britain’s Chancellor.

As the chart below shows, the spread (gap) between US and UK bond yields is at its long-term average.  Investors are buying and selling UK and US bonds in broadly similar ways and for fairly similar reasons, in other words – not because of some unique British conditions.

This was not the case in autumn 2022, when the Trust administration created some unique (and uniquely bad) British conditions, by attacking the independent institutions that help reassure investors, committing truckloads of money to tax cuts, and generally lacking political stability. See the 2022/23 spikes above the line on the chart.

So why are UK borrowing costs rising now? Back in my unhappy City days, I learned one useful, universal explanation for any market movement:  it’s complicated, there probably isn’t a single cause, and anyone who tells you there is one is selling something – or trying to explain to their boss why they just lost money on a trade.

That said, here’s one factor to consider in rising yields: investors think big Western economies are in long-term trouble because their politicians aren’t dealing with their underlying problems.  

Here I recommend Westminster bond sages start using the phrase ‘bear steepening’ to add cod-credibility to their commentary. This means that the yields on longer-dated bonds are rising faster than the yields on shorter-term ones, because investors think that longer-term loans are a worse bet.  

That’s because they think that in the long run (20+ years), the UK and US governments will have to do even more borrowing to fund themselves, flooding the market with bonds and pushing down prices. (More supply means lower prices.  And lower bond prices mean higher yields.)

The future implied by bear steepening is one where the UK economy grows very slowly, delivering weak tax revenues, forcing governments to run eternal deficits to fund unreformed public services.  And rising bond yields mean the costs of those deficits go up and up, potentially pushing those economies into a ‘doom loop’ of high borrowing and low growth. 

Mike Riddell, a bond investor at Fidelity International,  is among the market participants who argue that current bond movements are about something much bigger and badder than any one finance minister’s plans:

It’s not about inflation concerns, where the market’s medium-term inflation expectations are little changed since the beginning of November. Investors are instead demanding a higher-risk premia or ‘term premia’ to compensate them for owning longer-dated government bonds.

The obvious implication of this is that it’s just got a lot more expensive for everyone to refinance their debt. If this selloff continues, it’s going to push deficits wider over the long, which then risks a doom loop since deficits need to be funded by ever more sovereign issuance.

When we return to a UK political perspective, we see that this isn’t particularly positive for Rachel Reeves. It suggests that the markets don’t believe that she is going to resolve the structural economic problems that she inherited: weak productivity and growth; ever-more costly public services.  

That is a grim verdict for the markets to pass, but it’s not, ultimately, a comment on Reeves or the Starmer government, since those structural problems have been decades in the making, as a succession of chancellors ducked the challenge of trying to match tax revenues to public expenditure. 

Indeed, Reeves’s tax-raising Budget was arguably the most significant step towards fiscal consolidation the UK has seen for more than a decade; it will very likely be followed by some squeezing of public spending. That squeeze would be politically painful but might well offer some confidence to bears in the bond market. Ministers must also turbocharge their plans to strip out planning regulations and other red tape that makes it too hard to invest in Britain’s productive capacity. Bond markets hate bat tunnels, Chancellor.

Because markets are moving, there is some chatter at Westminster about Reeves’s Budget and her future, but the whisperers should bone up on how bond markets actually work – then accept that there was no real alternative to that Budget, and there is no serious alternative to Reeves and the things that she will do next.  

My advice, for what it’s worth: don’t blame the Chancellor for rising gilt yields – and don’t bet against her either.