The bond market, fiscal rules, growth, headroom, TAX RISES. Debates around UK fiscal policy have centred on these buzzwords. None more so than the bond market itself. It’s true that bonds, or gilts in the UK, exercise outsized influence on fiscal policy. More so than in decades past.
You will have heard frequent discussions about ditching the fiscal rules, end with the inevitable ‘well, the bond markets won’t allow that’. Cue the groans of backbench Labour MPs frustrated at the pace of change.
Symbolic of this frustration was Andy Burnham’s proclamation that we have to get beyond “being in hock to the bond markets.” As you’d expect, economists met this with scepticism.
Beyond the semantics of Burnham’s phrasing lies a real problem: markets are sending a clear signal and the UK’s fiscal credibility is in question. Gilt yields are rising and elevated relative to the rest of Europe. Even France, with its near constant political instability, currently borrows more cheaply than Britain.
Rising borrowing costs are constraining the government’s ability to plan durable fiscal policy. At the Spring Statement, the OBR raised its 10-year gilt forecast from 4.4 percent to 4.8 percent, at a cost of £10bn — equal to the entirety of ‘headroom’ plus change. After all, rising gilt yields alone necessitated a policy response at the Spring Statement.
But is that evidence of the UK being in “hock”? Has the UK uniquely tied itself to the bond market? What does this mean for the Budget?
At the heart of this debate lies a political dilemma: can the Government convince markets it’s fiscally credible without breaking its tax pledges — and will it accept the political pain that might entail?
To understand that, we need to go back to basics.
The Bond Market 101
The UK runs a budget deficit, i.e., it spends more than it raises in revenues. To fill that gap, the Government issues bonds, or in the UK, gilts; essentially IOUs promising to repay investors with interest at a set date in the future.
Bonds are the economy’s barometer. When confidence is high, investors buy; prices rise, and yields, the Government’s borrowing costs, fall. When confidence dips, investors sell, prices drop, and yields rise.
Bond prices and yields have an inverse relationship: when prices fall, yields rise, and vice versa. The price is what investors pay for a bond; the yield is the return they get from holding it — effectively, the interest rate on government borrowing. So when markets lose confidence, investors sell bonds, driving down prices and pushing up yields.
Bonds affect everything. They’re the quiet boss of the economy. When yields rise, so do the Government’s borrowing costs, tightening fiscal headroom and limiting how much the Treasury can spend without breaking its fiscal rules.
As we head into the Budget, that dynamic matters more than ever.
Why Gilts Matter
The argument that gilt yields are dictating fiscal policy appears, on the surface, to have some merit. So it goes: at the Spring Statement the forecasts for gilt yields rose, eroding the entirety of headroom, the Government was then forced into action. Enough said, right?
It is worth, however, investigating these events more closely. Since the pandemic, government debt around the world has been climbing. In the UK, it now stands at 96.3 percent of GDP, compared to 80.8 percent pre-pandemic.
With high levels of debt, the sensitivity of the public finances to changes in gilt yields is heightened. The higher the debt, the bigger the bill when yields rise. And the bill is massive. The OBR forecasts that the UK will spend over £111bn on debt interest, around 8.3 percent of total public spending. That’s around twice as much as the UK spends on defence.
This is a structural problem the UK cannot escape. Is it tantamount to being in hock? Or, solely the consequence of our own doing. Does it even matter? Not really, because there’s a simple remedy: reduce borrowing. Or as the Government has chosen, to forge a credible plan to do so in the future. After all, this is fundamental to another of the fiscal buzzwords – the fiscal rules.
The Credibility Game
The whole point of the fiscal rules is to assert fiscal credibility. They were designed to reassure gilt markets that effective institutional guardrails existed to rein in borrowing. Under the “Stability” Rule, debt must be falling as a share of GDP within a rolling five-year period.
There are many reasons for this. Primarily, fiscal credibility can provide a boost to business confidence and crowd in investment. If business doesn’t have to continually worry about tax rises, they’ll invest. And vice versa.
If the credibility of the public finances is in question, higher borrowing costs follow. If the Government doesn’t ensure stability, then yields are likely to rise further, leading to a crowding out of private investment. Encouraging investment has been a core theme of this Government, and fiscal sustainability its foundation.
Following this, you begin to understand why the Chancellor is so insistent that her fiscal rules are ‘iron clad’.
As Andy Haldane, former Chief Economist at the Bank of England, puts it, “well-designed fiscal frameworks are the cornerstone of macroeconomic success.” But on the above criteria the UK “fares poorly.”
Ultimately, fiscal rules matter less for what they constrain than for what they convey: confidence in the Government’s commitment to stability. That confidence, in turn, shapes how much fiscal space the Government truly has.
The Politics of “Headroom”
Effective fiscal frameworks are supposed to provide a cushion against shocks to the economy. This brings us to another buzzword, “headroom”. Fiscal headroom is the buffer between the government’s plans and the spending limits of its fiscal rules. This gap is essentially an emergency fund the Government can dip into to absorb shocks, including rising gilt yields.
Headroom stands at just £9.9bn — historically very low or “next to no[thing]” says Paul Johnson. With so little margin for error, any economic deterioration forces a policy response — as seen at the Spring Statement.
The alternative, though, is far from painless. Increasing the buffer is smart fiscal policy— bordering on the obvious. Doing so reduces the uncertainty around tax rises and increases the Government’s ability to absorb external shocks, without requiring a policy response.
But this comes with substantial political risk. Various figures have estimated the Government’s deficit to be around £20-40bn. Topping up ‘headroom’ would require further revenues to be raised. With the Government facing substantial internal opposition to spending cuts, and the Spending Review locking in capital and departmental spending, they will have to look primarily at tax rises to fill this hole.
Yet more tools have seemingly been taken out the Government’s fiscal arsenal. In their manifesto, Labour committed to not raising the “Big 3” revenue streams: income tax, VAT, and national insurance — as well as corporation tax. Raising substantial revenues outside those pledges is already a challenge. The prospect of finding even an extra £10bn has the potential to be a political nightmare.
That’s the crux of the bind. Creating more headroom would strengthen credibility, but it means raising significant revenues and breaking manifesto pledges.
Crucially, a downgrade of the magnitude this Government is facing is fairly typical. Since June 2010, there have been eight downgrades of £20bn or more, so maintaining such a narrow buffer leaves the public finances exposed to an entirely plausible scenario.
If increasing the fiscal buffer is politically off the table, then we must better understand why gilt yields are rising in the first place.
Explaining UK exceptionalism
Rising bond yields are hardly a UK-centric phenomena. Government bonds, after all, are a publicly traded commodity, are substitutes for each other, and therefore track each other closely. Rising yields globally almost certainly push up UK government borrowing costs. This is definitely a factor with rising gilt yields; US Treasuries have been rising in the face of Trump’s tariff war, as well as Eurozone yields, in the wake of Germany ditching it’s “debt brake”.
Yet, the UK seems to be uniquely impacted by these external shocks. After all, UK borrowing costs are the highest in the G7.
A recent CfM-NIESR survey looked at why this is.71 percent of panellists attributed this to higher inflation expectations, while 68 percent said rising yields reflected concerns over “UK public debt sustainability.”
Again, neither phenomenon, especially on the UK’s fiscal position, are UK-specific. NIESR’s David Aitkin notes that France, Italy and the US all carry higher debt levels yet borrow more cheaply, arguing that fiscal indiscipline and political volatility are “hardly uniquely British problems.” So, therefore, cannot be entirely to blame.
One answer may lie in who’s holding UK gilts, and who isn’t. A quiet driver of rising long-term gilt yields is the slow decline of traditional pension funds. For decades, defined benefit (DB) schemes, where workers are promised a fixed income in retirement, were steady, long-term buyers of government debt. As these schemes close and are replaced by defined contribution (DC) pensions, that reliable source of demand is fading.
DC schemes, by design, are more market-driven, with savers’ money spread across global equities and diversified funds rather than locked into UK bonds. In their place, overseas investors and large asset managers have stepped in. These players are far more sensitive to shifts in returns, risk, and currency costs — and far quicker to move their money elsewhere if conditions change.
The result is that Britain’s gilt market has become more global, more mobile, and more exposed to the whims of international capital than at any point in recent memory.
The shift from DB to DC is, again, a global story. But it bites harder in the UK. Over 80 percent of private sector DB schemes are now closed, stripping the gilt market of a once-reliable long-term buyer. With the average maturity of UK debt around 14 years, far longer than in most advanced economies, and roughly a third of gilts now held by overseas investors, Britain feels the loss of that stable domestic demand more acutely than most.
Whilst much of this is concerning, it still doesn’t provide a complete explanation for UK exceptionalism. As Aitkin argues, these factors, from shifting gilt ownership to weak fiscal credibility, act as “amplifiers, magnifying fiscal and inflation pressures.” The same forces raise yields abroad, but they press harder on the UK.
Britain’s high debt, long maturities and shrinking domestic demand for gilts make that political bind even tighter. Every lost ounce of credibility costs more here than elsewhere.
The Cost of Credibility
If bonds are the economy’s barometer, then the outlook looks weak. As a result, the Government faces a tough balancing act. They need to cement fiscal credibility, but face a political challenge in raising significant revenues and cutting spending.
If there’s one takeaway, it’s this: operating like fiscal constraints don’t exist isn’t an option. To do so, risks further fiscal volatility and an eternity of policy responses.
The Government can’t escape that constraint, only how it chooses to manage it.
One thing is for certain, the UK isn’t “in hock” to the bond markets. It’s the political choice of this Government to devote the limited funds it has to actual spending, not to building a bigger buffer.
Whether they take the step to increase “headroom” beyond £9.9bn, will depend on the Government’s tolerance for potential political pain. It may prove an uphill battle, considering how hollow its fiscal toolkit has become.
Yet failure to act is also a throw of the dice — a political gamble of another kind. Until the UK can get the public finances on a sustainable footing, the conversation will remain circular. Centred on the ever-discussed buzzwords, the relentless rumour-mill on tax rises will continue. Yields will continue to rise, and confidence will plummet.
Until credibility and sustainability move from rhetoric to reality, the bond market will continue to disrupt – however much politicians wish it wouldn’t.