Six reasons why UK gilt yields rose after Labour’s budget

The market has reacted decisively and Downing Street should take note

November 4, 2024, 3:47 PM

Rachel Reeve's budget speech coincided with 'an ugly moment in the US Treasury bond market' — Rachel Reeves's budget speech coincided with 'an ugly moment in the US Treasury bond market'

The verdict of the gilt market on the new Labour government’s first UK budget was not exactly rapturous.

While the yield on the 10-year gilt was 4.20 percent and actually drifted lower as Rachel Reeves, the chancellor, began her speech on Wednesday, the UK government’s securities market had a nervous rethink about the inflation risk implicit in an expansionary, pro-growth template and quickly repriced the bellwether cost of borrowing.

The 10-year gilt yield rose as high as 4.57 percent on October 31 but trades a tad lower at 4.46 percent as I write this on November 3.

This rise in gilt yields is nowhere near as traumatic as what we witnessed after Liz Truss’s Tory mini-budget in September 2022 – when the LDI (liability driven investment) doom loop led to a 100 basis point spike in yields after a spasm of gilt selling by pension funds facing margin calls – yet it is not without macroeconomic significance either.

So why the sharp rise in post-budget gilt yields? Six reasons.

One, the chancellor’s speech coincided with an ugly moment in the US Treasury bond market, where yields on the 10-year Uncle Sam note have risen from 3.60 percent to 4.32 percent since the last Federal Open Market Committee (FOMC) conclave on September 18.

The bearish momentum in the US bond market has been amplified by strong US payrolls and retail sales data, inflation angst, and fear of Donald Trump’s plan to impose tariffs on US imports as well as to deport millions of illegal immigrants.

The budget set out a looser fiscal policy than was expected by the consensus in the City of London

Higher US Treasury bond yields on the eve of a decisive coin-toss election were bound to exert upward pressure on UK gilt yields, especially since EU growth data has also been stronger than expected and market psychology is nervous about France’s political malaise and budget/public debt woes.

Two, the bearish pivot in global bond markets does not negate the fact that the spread between UK gilt yields and German Bunds has widened sharply and is now at its highest since the fateful Truss gilt crisis two years ago.

The gilt market has obviously repriced the inflation risk premium in the 10-year UK government borrowing rate after it digested the spending estimates in the budget speech.

Three, the budget set out a looser fiscal policy than was expected by the consensus in the City of London as the rise in government borrowing and spending metrics in the Labour budget was higher than expected, it was thus logical for the debt market to slap on a higher inflation risk premium on the 10-year gilt note.

After all, the higher the inflation risk implicit in the budget, the lower the odds that the Bank of England will cut base rates at its scheduled Monetary Policy Committee meetings this winter.

Andrew Bailey, governor of the Bank of England, has consistently warned about UK service inflation, now 4.9 percent, since the central bankers’ salmon fishing jamboree at Jackson Hole, Wyoming, in August.

Four, there is also an insurance component in the gilt market’s post-budget higher inflation risk premium. If UK growth disappoints due to a synchronised global slowdown in 2025, HM Treasury borrowing metrics will only move higher. Britain has historically been the most inflation prone economy in Western Europe since sterling’s Black Wednesday – the forced ERM exit debacle in September 1992.

Five, the proximity of the US presidential election and the November FOMC this week also contributed to an event risk premium in gilt yields since these are the two great known unknowns in global financial markets. In fact, the Old Lady of Threadneedle Street also meets on November 7, another obvious source of event risk.

Six, the rise in gilt yields has had a mini contagion impact on major UK asset classes. Sterling has dipped against the US dollar to 1.296 and also weakened against most G10 currencies, while British domestic shares in the FTSE 250 index have also fallen.

The bond vigilantes in the Square Mile have unquestionably delivered a rebuke to Labour and a Downing Street in its political honeymoon should not ignore this warning shot on fiscal discipline.

Matein Khalid is the chief investment officer in the private office of Abdulla Saeed Al Naboodah and the CEO designate of a venture capital firm. He is also an adjunct professor of real estate investing and banking at the American University of Sharjah