Putting British Bonds’ Alleged Budget Blues in Context

Here we go again? Long-term UK bond yields have jumped to their highest since mid-2008. Which means they are above levels seen amid the so-called mini budget crisis of autumn 2022, when spiking yields prompted a fiscal policy U-turn by then-Prime Minister Liz Truss. Headlines claim this time could be even worse, with the confluence of high borrowing costs, elevated public spending and flatlining GDP growth poised to ignite a fiscal crisis. Sounds dire. Reality looks a lot more mundane to us.

It is true UK 10-year Gilt yields are up over a percentage point since mid-September. It is also true this has raised interest costs, as the UK has relatively more floating-rate debt than its peers. And it is true yields’ rise coincided, in part, with the Halloween release of Chancellor of the Exchequer Rachel Reeves’s Budget, which brought higher spending and taxes. And it is true that, during this window, the UK’s monthly economic indicators have had some setbacks while Q3 GDP was revised down to a flat reading.

At the same time, we don’t think it is accurate to say there is an airtight causal relationship here. As Exhibit 1 shows, UK rates’ rise is part of a broad, global rate move. 10-year Gilt yields have moved in virtual lockstep with 10-year US Treasury yields. Yet US GDP growth has shown little weakness. Taxes aren’t rising, and there is little to no realistic talk of an impending US fiscal crisis. French and German yields, while lower, have trod a similar path. Both are locked in political crises with budget uncertainty a central feature. The fundamental situation in each nation is different, but their rates are highly correlated. Global forces appear to be holding sway over local. This isn’t like 2022, when UK yields rose 2.74 percentage points (ppts) in a little over two months while US Treasury yields rose just 1.1 ppt.^[i]

Exhibit 1: UK Gilt Yields Aren’t an Outlier

Source: FactSet, as of 1/13/2025. Benchmark 10-year government bond yields, 6/28/2024 – 1/10/2025.

Another dissimilarity between then and now: UK pension funds aren’t blowing up. Then, Gilt yields soared not because Truss’s plans for very modest tax cuts broke the market, but because over-leveraged pension funds had to raise cash in a hurry to meet margin calls. Selling illiquid assets was off the table, so they turned to the easiest, most liquid security in their portfolios: Gilts. Forced selling hit prices, triggering more margin calls, forcing more selling, and the vicious cycle didn’t halt until the Bank of England (BoE) backstopped the industry. We aren’t seeing reports of forced selling this time. Surprise, there is no talk of BoE intervention.

Today’s talk of fiscal crisis looks more political than economic. There is a lot of talk about the Treasury being out of headroom. What this means: The government is running up against its self-imposed borrowing rules. In the Budget, Reeves left a bit less than £10 billion of wiggle room between projected spending and the maximum she would have been mathematically able to add and stick to projected deficit limits, which are based on the Office for Budget Responsibility’s (OBR) forecasts. With higher interest costs now projected to devour most (if not all) of this £10 billion, headlines warn she will either have to cut spending plans or raise taxes again to cover a shortfall. Given many of the spending increases went to public sector wage hikes, most doubt spending cuts will be on the menu, raising tax hike fears—and therefore recession fears.

Far be it from us to try to predict what any politician will do, though we note that Reeves tweaked the fiscal rules in this Budget, and she could do so again. Arbitrary rules can make arbitrary shifts, and Labour has a big majority. Doesn’t mean she will, but there is nothing automatic about further tax hikes.

Either way, the recession chatter seems premature to us. Yes, GDP flatlined in Q3 and yes, all manner of headlines and surveys pinned this on Budget uncertainty. But when we actually look at the data, we see household spending accelerating to 2.2% annualized and business investment speeding to 7.9%.^[ii] The main weak spots were the nonprofit sector and trade. The ups and downs in the October and November indicators that have trickled in thus far look to be in line with their ups and downs throughout 2024. We can’t discern some sudden weakening here.

It also seems like a stretch to argue growth will take a massive hit once Reeves’s new taxes take effect in April. The most relevant to economic activity are a small capital gains tax increase and small payroll tax hike. The UK’s long history of capital gains tax changes doesn’t show a strong relationship with its economic or market performance. As for the payroll tax, we have seen the many, many, many reports from small businesses warning this will hurt margins and may force them to trim headcount. We love mom-and-pop shops and don’t like seeing businesses struggle—nor do we like seeing people get their hours trimmed or their position cut. But in terms of the macroeconomic effect, small tax changes like this tend to be an incentive to do more with less. Businesses can cut costs without cutting output. And we have reams of data showing changes in employment levels don’t dictate economic growth. We are sorry if this sounds cold, but markets are cold, and navigating them often requires you to turn off your heart and think rationally.

Lastly, the whole discussion surrounding yields seems entirely illogical to us. Many of the analysts warning tax hikes are a threat now are the same ones warning tax cuts were the death knell in 2022. You can’t have it both ways. Then, too, yields fell pretty much all November, by which time the Budget and its widely feared implications were well known. Did markets think the Budget was the bee’s knees in November, only to rapidly change their mind in December despite no discernible change? It doesn’t wash.

To us, this spell is a timely reminder that bond markets are volatile. Over time, they generally swing less than stocks. But they still swing, for any or even no apparent reason, as investors’ moods shift. Just like stocks, bond markets move on sentiment in the short term and fundamentals in the medium and longer term. Sometimes those sentiment swings take stocks and bonds in different directions, sometimes the same direction. We suspect this bout of volatility stings extra hard because stocks have taken a hit, too. But volatility tends to be fleeting, over before you know it. Patience and a deep breath are usually the best approach.