Bond-market lessons for Labour’s leadership hopefuls

Labour’s drubbing in the local elections on May 7th has started two crucial contests. The first, to replace Sir Keir Starmer as prime minister, is already getting messy. The second, between leadership hopefuls and the bond market, could get ugly. Andy Burnham, one would-be prime minister, has moaned about Britain being “in hock to the bond markets”. One MP supporting Mr Burnham said the bond markets would “have to fall in line” if he were elected. Investors in gilts (British government bonds) have hit back. For ten-year gilts the yield (the rate the government pays to borrow) rose by nearly 0.2 percentage points on May 11th-12th alone.

Many Labour politicians see the gilt market as a bully that will back down if you stand up to it. In reality, the government spends more than it taxes and must persuade investors to fund the gap. Those investors ask two questions: how risky is British government debt? And, adjusting for that risk, can they get a better return elsewhere? The answers are largely determined by global forces or structural problems with the British economy that cannot be magicked away. No leadership hopeful can fully shake off the gilt market’s whims. But fiscal incontinence makes matters worse; avoiding it is the best way to escape the market’s wrath.

Since the Iran war began yields on ten-year gilts have leapt from 4.2% to a high of 5.2% in late April. This trajectory is a global phenomenon; sharply rising energy prices are increasing inflation everywhere. Markets expect central banks will need to raise interest rates to bring price rises back to target. But Britain is unusual in how badly it has been damaged. The country’s yields, already the highest in the G7 group of large rich countries, have seen the biggest jump since the Iran war began—double that of Germany (see chart 1).

Britain’s expensive debt is partly caused by exposure to inflation and high energy costs. In the years before the Iran conflict high prices had proved stickier in Britain than elsewhere. As late as February annual inflation was 3% (against 1.9% in the euro zone). Combine this with Britain’s over-reliance on gas imports, and investors have been persuaded that Britain faces a uniquely virulent bout of inflation.

Then there is the term premium, the extra compensation that investors demand for holding longer-dated debt. Analysis by Goldman Sachs, a bank, suggests that the ten-year term premium in Britain has risen by over two percentage points since 2022, compared with around one point for the European Union over the same period (see chart 2).

Poor fiscal choices by consecutive governments contributed to this. Under the Tories, Liz Truss’s unfunded tax cuts in 2022 gave bond traders the jitters; so did Labour’s promises at the last general election not to raise taxes on “working people”. Even today the government’s plan to get the deficit down to 2% of GDP by 2029-30 relies on future tax rises that few expect it to enact. Still, Britain’s higher-term premium cannot be explained by government profligacy alone: France and America both have worse government deficits and debt levels, yet can borrow at cheaper rates.

An alternative explanation rests on the changing structure of the gilt market. Sturdy domestic pension funds, once the bedrock of gilt demand, have bought fewer bonds in recent years. Their place has been taken by overseas investors, who are quicker to flee when risk rises. The Bank of England has added to the pressure by continuing to sell off the gilts it accumulated during years of quantitative easing. The Federal Reserve has paused its equivalent programme. With a glut of sellers and fickle buyers, the gilt market has become particularly quick to price in risk.

David Aikman, the head of NIESR, an economic think-tank, suggests a further reason: Britain is unusual among rich countries in paying a true “market-clearing rate” for its debt. Investors in Spanish and Italian bonds accept lower yields, expecting that the European Central Bank (ECB) will cap them if they rise too far (as it did in 2022). By suppressing price signals the ECB is storing up problems down the line. But this points to a wider truth. The ECB and its German backers provide protection to euro-zone bond markets in troubled times; America can rely on vast demand for Treasuries as the world’s safe asset. Britain, by contrast, stands alone. That warrants a higher risk premium.

A prime minister cannot fix most of Britain’s gilt-market woes in the short term. They cannot quickly halve Britain’s debt or end its dependence on energy imports. Erasing perceptions of Britain as inflation-prone will take years. And, short of joining the euro, Britain will never benefit from belonging to a currency bloc.

But the government can provide some relief by demonstrating fiscal credibility. Uncertainty about the identity and policies of Britain’s next prime minister have already pushed yields higher in recent days. If candidates go further by suggesting large increases to borrowing—Mr Burnham has intimated support for carving defence spending out of any fiscal rules—investors will take fright.

A jumpy bond market is not some abstract risk. The Institute for Fiscal Studies, another think-tank, reckons that if current yields were pencilled into fiscal forecasts at the next budget, debt-servicing costs in 2029-30 would be roughly £7bn more than thought in March. That’s the equivalent of a penny on income tax. With credible tax and spending plans aspiring prime ministers can set Britain on a path to reducing its bond-market exposure in the long term. If they don’t, as Ms Truss found out in 2022, the gilt market will have no choice but to impose fiscal prudence on them. ■