Prime Minister Andy Burnham faces a critical juncture as high government borrowing costs, often attributed to the influence of "bond vigilantes," cast a shadow over his administration. The term, coined by economist Ed Yardeni in the 1980s, describes investors who sell or threaten to sell government bonds to punish fiscal irresponsibility.
These market forces are widely credited with contributing to the downfall of former British Prime Minister Liz Truss in September 2022. Her mini-budget triggered a sell-off of UK government bonds, known as gilts, sending yields close to 5 percent and causing a crisis in pension funds that required emergency intervention from the Bank of England.
Now, the UK's borrowing costs are at their highest levels since the 2008 financial crisis. Ten-year borrowing costs have reached approximately 5 percent, while 30-year yields have hit 5.8 percent, their highest since 1998. These elevated yields increase the cost of servicing the UK's national debt, estimated at £3 trillion, with annual debt servicing costs at £120 billion.
While current yields are higher than during the Truss period, the market reaction has been less volatile. Analysts suggest the market has "priced in catastrophe" and is adopting a "wait and see" approach ahead of John Healey's first budget. Investors are reportedly hesitant to purchase long-dated gilts, with some indicating that yields might need to approach 6 percent to attract renewed interest. Concerns persist about a lack of perceived economic growth and what some describe as "politics of envy."
Experts point to a "fiscal trap" where deteriorating public finances and increased spending widen the deficit. The concept of "fiscal dominance," where investors doubt central banks' ability to control inflation without risking government insolvency, is also a growing concern. This dilemma could lead policymakers to tolerate higher inflation.
The composition of the gilt market has also shifted. Domestic pension funds and insurers now hold only a third of gilts, with the Bank of England owning 18 percent and foreign investors controlling another third. Hedge funds and non-financial corporations are also gaining influence.
To regain market confidence, analysts suggest that the government must demonstrate a commitment to working with the private sector to achieve growth. Recommendations include outlining serious spending cuts in the upcoming budget and potentially a modest increase in income tax for the middle class to help reduce debt. Some allies of the Prime Minister have indicated an understanding that difficult decisions regarding spending on areas like the pension triple lock and welfare system are necessary.
However, economists also caution against further tax increases, arguing that the UK has reached "saturation point" and that higher taxes could harm future growth. The potential for policies such as wealth taxes, which could reduce tax revenue and drive talent abroad, is seen as a significant risk that could further destabilize borrowing costs.