The Myth of the Magical Money Tree - What is Happening in Gilts?
By Mike Newton January 12th 2025
The bond markets always find you out in the end. From them no secrets are hid. I learned this during my time working at the Bank of England.
When the government decided to destroy private sector investment, and transfer the confiscated wealth to a stagnant and bloated public sector, without doing anything to boost productivity or reduce expenditure, did anybody seriously expect that this would be consistent with stable bond markets? To assume that gilt markets would not be unsettled by this suggests a complete ignorance of the immutable iron laws of economics, and also a total misunderstanding of the 'animal spirits' that drive vast pools of global capital on which the UK relies.
Gilt yields are now at, or close, to 1990s levels across most of the curve. This reflects a lack of confidence in the UK's ability to service its debts. It is the most extraordinary situation for a G7 country, with huge capital markets and a free-floating currency, to be in.
The people whom the UK needs to lend it money have looked at Labour's fiscal plans, and said 'no thanks.' They are nervous in the extreme.
Talking to a very savvy Asian investor recently, of the type that the UK needs to buy its bonds, he was feeling he should be starting to treat the UK as a 'yielder', which is the shorthand that the market uses for countries with unstable fiscal outlooks and processes.
It is very worrying indeed that the UK is now being classed as potentially similar to Mexico or South Africa, but one can see the logic. Left-leaning administrations, who tolerate capitalism rather than embrace it, and have no ideological adherence to sound money beyond the expedient, are always going to have to issue higher interest bonds simply because the market does not trust them.
So what policy alternatives does the government have? There are a few options available: wait and see (which seems to be plan A), cut public expenditure and / or raise taxes, or try to change the maturity profile of the debt.
'Wait and see' was the strategy employed during the Urgent Question this Thursday, and to be fair it did not make the situation any worse. Rachel Reeves decided not to attend using her China trip as an excuse and so Darren Jones, Chief Secretary, was left to block.
The problem with this strategy is that while it buys a little time, it offers the markets no meat. The Chief Secretary is not an experienced (or substantive) enough figure to reassure brutally sharp fund managers who neither understand, nor want to understand, the 'he said she said' nuances of recent British political history in which he specializes. What they want to hear from the Front Bench is how they are going to get their money back.
If Reeves had bothered to attend, then the 'Black Hole' argument would no doubt have been dragged out, along with other familiar platitudes. The problem with this is that the markets have discredited the underlying math she relies on, and a discredited Chancellor is one that demands a big ‘ole risk premium.
Cutting public expenditure is a political nuclear option but we may yet get there if the market demands it. Another 100bp on yields and we will be in the territory where Reeves has to have that conversation with the Parliamentary Labour Party.
Tax rises are also a possibility, and if there were to be substantive public spending cuts, a political necessity. These would likely be ultra-punitive, and 'for Socialist demonstration purposes' as much as revenue raising. A wealth tax of between 2-5% would seem almost certain in this scenario.
No doubt this would lead to a further collapse in private sector consumption and investment, but it could be sold politically to keep the Labour Party together as a quid-pro-quo for public sector economies, however skin deep.
The fact that the economy would start to resemble Romania or Yugoslavia in the 1970s, with the state dominant and controlling an increasingly large proportion of resources, would be immaterial to Labour. Economic growth would be on its knees and tax revenues would fall further as GDP shrunk, while government debt remained the same size. The problem would not go away using the fiscal mix outlined above, but it is the only saleable one to the PLP.
The Treasury might try to increase the maturity profile of the UK's public debt, which means borrowing more for longer terms so one can basically push the problem into the future. The way in which 30-year debt has been trashed, however, suggests that with markets in their present mood, they will not be conned by this. And the average maturity of UK debt is around 15 years already, among the highest by international standards. This card has been played.
The road ahead looks uncomfortable, with no panacea politically or economically. The worry now has to be that a rise in yields turns into a buyers’ strike, which forces the Treasury into finding emergency liquidity where it can.
The most obvious source is the Bank of England, although the Bank's capacity to effectively undertake what would be unlimited quantitative easing would be sorely tested and have huge implications for macroeconomic stability. At some point the government would have to look elsewhere, and the IMF would be the obvious choice.
The US, as part of the post-war monetary settlement, controls the IMF as the largest shareholder, and Fund loans require a certain amount of Congressional approval given American taxpayers' money is at risk.
I worked in Asia for several years covering the region as an economist and markets analyst for HSBC. During that time I got to know South Korea very well, which had been a recipient of an IMF programme in the late 90s.
At this time Korea was a major US strategic partner and the IMF bailout that it received was relatively friendly. However, behind closed doors I heard endless complaints by senior Korean officials about how the US had ripped them off, and when I took one of the architects of that program, David Lipton, on an official visit many years later, it was clear that Uncle Sam had concerns about the Korean commitment to market reform that was part of the loan agreement.
Neither side was happy. And this was under a moderate president in Clinton.
The point I am making is that these programs are no rose garden, and even if the US has good relations with a country, the loans come with history-altering conditions.
US-UK relations will be dire from the moment of the Inauguration onwards. If our country goes 'cap in hand' to the IMF, it will be a dark outcome indeed. We will feel the full force of MAGA wrath.
Predicting the markets is a hard school but I will offer this: that a package of low-conviction public spending cuts and punitive tax rises will have to be tried, and perhaps soon. If this is not effective the way is open to Uncle Sam and the IMF.
That this has moved from being a zero probability event to something that is now being seriously talked about in a short space of time, by serious people, is perhaps the most devastating comment one could make about Labour and the economy.