Why the Bank of England may need to step in to calm the bond market storm

It is seventeen years since the interest rate on such debt was this high. These higher interest rates are largely the result of concerns over global debt levels, an expected proliferation of trade tariffs, and the ongoing strength of the US economy. It is however a persistent feature of UK politics and its media that we look for an explanation, and accord blame, closer to home. That is understandable. The government’s opponents always seek to apportion blame to domestic missteps. And domestic policymakers are loathe to admit their relative impotency in setting the price for government debt. At just 3% of the global economy much of the UK’s economic weather originates offshore. A Jet Stream of capital markets could be bringing a US-generated financial storm to the UK.

This is not to say that the UK’s economic stance is not playing a role. The UK economy has slowed sharply since the summer. That slowdown has been a direct reaction to government missteps. Tax increases in the October Budget - however well-intentioned - have knocked the stuffing out of business confidence with insufficient countervailing enthusiasm. Investors in UK government debt now suspect higher inflation and a weaker pound will be the near-term result of this policy mix. This makes UK government debt less attractive for a given interest rate.

At a global level investors also have plenty of options. Japanese debt is offering a positive interest rate for the first time in a generation. Enthusiasm for US shares is being fuelled by expectations for a corporate tax cut from the new Trump administration. This all spills over into the demand for UK government debt.

What will frustrate Labour’s economic thinkers is that recent borrowing to fund health, education, and higher capital investment risks getting derailed by these higher borrowing costs that act to make such investments in the UK’s future more expensive. But government is as much how you respond to economic conditions, as how you engineer them. Financial markets are demanding a rethink.

Before the government tears up its spending plans, where does the Bank of England sit within all this? As usual, in a tricky spot. There is a respectable school of thought that the Bank should sit tight and the pressure from bond markets should be alleviated by the government coming forward with more pro-growth, more efficient public spending proposals. The Treasury, unable to rely on the Bank stepping in or bond markets regaining their composure, are already working up contingency plans that involve cuts in spending. But there is another view - and one that may be forced on the Bank in short order - that swift intervention is justified on the basis that despite cutting interest rates twice since August, interest rates for UK firms and households look set to rise. That disconnect has the hallmarks of a breakdown between the primary policy tool – the Bank’s interest rate – and the financial conditions faced by the real economy. With the Bank of England continuing to sell government debt back to the private sector in an exercise called Quantitative Tightening there is an argument for pausing these sales while bond markets stabilise. It could credibly be argued that events in the US will become easier to understand the other side of next week’s Presidential inauguration so such a move would be time-limited rather than simply an act of bailing out the government.

Such a move would not be without controversy. It would stir memories of the Bank’s successful intervention around the Mini Budget in 2022 and lend support to those drawing parallels between the Kwarteng and Reeves’ Budgets. Such an intervention would also draw the Bank back into the political realm. It is an arena Bank officials are desperate to steer clear of.

In Westminster there will be an active debate on how to interpret what is going on in financial markets. On the one hand the UK’s public sector debt is the second lowest in the G7. That the UK has a problem with the sustainability of its tax and spending plans does not make it an outlier. Similarly, whilst the UK’s growth in GDP and GDP per head has been sluggish, it is not at the bottom of either league table on any meaningful time horizon. However, the pinch points on sentiment towards UK government debt appear to be three-fold.

Firstly, the fears of stubborn inflation. Investors appear concerned that the UK’s approach to its energy policy and costs of employment will translate into higher consumer prices. Despite having been lower than the global average for the last eight months, UK consumer price growth is back in the crosshairs amidst narrow spare capacity in UK energy markets, and employers passing on higher payroll costs to selling prices. One of the strategic reasons that Chancellor Reeves is currently in China is that China is currently one of the big exporters of deflation into the world economy. Tapping into lower import prices when domestic price pressures are growing is one of the ways to keep a lid on the UK price level.

Secondly, the UK has a long-dated problem in the high cost of deploying capital. This theme comes up again, and again, and again in talking to businesses. There a lots of highly attractive investment propositions in the UK that will generate high paying jobs and make the economy more productive. However the costs and time in deploying capital are exorbitant. When benchmarking the cost per mile of High Speed Rail, the cost per megawatt hour of nuclear power, the time to approve planning applications for datacentres, energy connections, and residential infrastructure the UK looks like an outlier. This is a huge impediment to UK growth and fiscal resilience.

Thirdly, there are active disincentives for investors to allocate to UK financial markets. One of the reasons that the US has been able to grow its economy so much faster than its competitors in recent years has been its low cost of capital fuelled by attracting European and Asian household savings. Allocations of the UK’s £3 trillion pension industry to its own economy have been sharply declining over more than thirty years raising the cost of capital in the UK. Stamp Duty on UK shares and the removal of Dividend Interest Tax relief continue to act as an active impediments to owning Sterling assets. Less exposure to UK assets means a lower demand for Sterling – with a direct spillover to the depth of liquidity in the UK bond market. Recent Bloomberg analysis of bond market liquidity show the UK becoming an international outlier.
Address these three impediments and the government has a fighting chance of reversing sentiment. However financial markets are rarely patient. The Bank of England may need to step in to avoid this lack of patience becoming something more unpleasant.