What bond markets think of Rachel Reeves’s Budget

Chancellor Rachel Reeves faced a difficult balancing act in her first Budget: increase investment and change fiscal rules, but avoid the kind of bond market meltdown that followed the 'mini-Budget' two years ago. It looks as though she largely succeeded.

Climbing gilt yields before the Budget gave rise to fears of a bond market pushback. The 10-year gilt yield climbed from 3.75 per cent in mid-September to 4.3 per cent the day before the Budget. The gap between 10-year UK and German government bond yields also widened, increasing from 1.6 per cent in September to almost 2 per cent on Tuesday.

Though some of this was pre-Budget jitters other forces were also at play. Over the past few weeks, bond markets have had to digest fluctuating oil prices, changing Federal Reserve interest rate expectations and uncertainty about the looming US election result

How the bond market reacted

Immediately after the Budget, the 10-year yield dipped to 4.23 per cent although ticked up to 4.4 per cent after investors had a chance to pore over the Office for Budget Responsibility's (OBR) report. These revealed the chancellor would have very modest headroom against her debt rule by 2029-2030, and set out that the Budget represented a “large sustained increase in spending, taxation and borrowing”. 

There was more to spook markets, too: debt issuance is expected to rise to almost £300bn this year, the second-highest level on record. Reeves also tinkered with her fiscal rules to free up extra funds for investment – a move that could have risked damaging her fiscal credibility. All things considered, the market reaction looks remarkably muted, at least by Trussonomics standards. Yields ended the day at levels last seen shortly before the election, as the chart below shows.

Yet investors were mollified by the news that Reeves was on track to meet both of her fiscal rules early, plus figures from the OBR suggesting that net financial debt would fall as a proportion of GDP by 2027-28. The chancellor also deserves credit for her careful messaging during the Budget announcement. 

What Reeves did to keep markets on side

The biggest news for bond markets was the tweak to the second fiscal rule freeing up more space for investment. Reeves ‘pre-announced’ this last week, meaning investors had plenty of time to digest the change. Though fiscal rules were relaxed in one sense, Reeves tightened them in another, stating that both the stability and investment rules would hold over a three-year (rather than five) period. 

The chancellor has also put guardrails on investment spending by ensuring that the portfolio of new financial investments will be delivered by ‘expert bodies’ such as the National Wealth Fund, which must earn a rate of return at least as large as that on gilts. The new Office of Value for Money will recommend system reforms to save taxpayers money, while the National Infrastructure and Service Transformation Authority (Nista) will advise on whether a proposed investment will deliver economic growth. 

An OBR review into the ‘£22bn black hole’ in public finances gave Reeves another chance to flaunt her commitment to economic stability. According to Reeves, the Conservative Party did not disclose all the information needed ahead of this year's Spring Budget. She added that “had they known about these undisclosed pressures that have since come to light, then the spring budget forecast for spending would have been, and I quote again, materially different”. Former chancellor Jeremy Hunt had tried to block the report, arguing that publication on Budget day allowed it to be used as a “political weapon”.

No institution bashing

The chancellor also ensured there was strong institutional oversight of her new Budget measures. While Truss sidelined the fiscal watchdog and questioned the Bank of England’s independence, Labour has strengthened the Office for Budget Responsibility’s role through a new Budget Responsibility Bill. Reeves also used her first Budget speech to confirm that she would adopt all measures recommended in a review by the fiscal watchdog. The chancellor also stressed her support for the Bank of England, and as a former economist at the central bank, thanked the Bank's staff for their help. 

Earlier this month, Sushil Wadwahni, a former member of the Monetary Policy Committee estimated that a higher budget deficit under Liz Truss was responsible for only around a quarter of the rise in gilt yields after the 'mini-Budget'. Remarkably, ‘institution bashing’ may have contributed about the same amount. Though the chancellor's callouts to the BoE and the OBR might have sounded like politicking, we should not underestimate the impact of backing the UK’s economic institutions.