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Rachel Reeves finds herself stuck between Liz Truss, Donald Trump and Labour MPs. This week, the bond market illustrated what an awkward spot that is.
Ever since the general election that swept Labour back to power one year ago, Reeves has been tasked with delivering the impossible. Somehow, to balance the books, she has to cut spending (unpopular with many MPs in her party and the vulnerable constituents they represent), raise personal taxes (a breach of a manifesto pledge) or raise borrowing (which tests the patience of bondholders). Rather her than me.
Lively scenes in UK markets in recent days illustrate just how tight a corner she has painted herself into. The welfare reform bill that she has been championing for months, and which involves large and rather ham-fisted benefits cuts, faced a large rebellion from MPs of her own party and had to be heavily watered down.
On Wednesday in parliament, it all came to a head. Prime Minister Keir Starmer stopped short of immediately pledging her his unerring support, and she sat behind him appearing tired and visibly upset — catnip for the diehard Reeves baiters in financial markets who frequently refer to her, with more than a hint of misogyny, I must say, as “Rachel from accounts”. (Yes, that nickname is worse than “Spreadsheet Phil” for Philip Hammond, and if you’re not sure why, I suggest you ask a few women.)
The precise cause of her distress is unclear and frankly none of our business. But the matter-of-fact financial markets, spooked by the notion that either she may not have much longer in office, or that bondholders may end up as the patsies here, did not stick around to find out.
Sterling, which has been flying higher this year thanks to the slide in the dollar, took a hit, down 0.8 per cent on the day. More worrying still, UK government bonds gagged. Prices fell in line with the currency — a worrisome pattern generally reserved for emerging markets — generating a rise in yields on long-term debt approaching the same league as the crisis of late 2022.
To be clear, this week’s wobble was not even close in severity to that famed Truss moment. It was not a full-blown crisis of confidence, the yield surge was shorter and less pronounced, and it did not trigger any secondary explosions, as Truss’s ill-fated spending plans did with the pensions industry at that time. There was no need to activate the Bank of England’s crisis response team, and some big investment houses happily bought the dip.
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But the whole episode shows how dark a shadow is still cast by Truss, nearly three years after her six-week stint as prime minister ended. Holders of UK government bonds are still rather traumatised by that crisis and, as we saw this week, quick to take cover just in case of a rerun. This is simply too small and flighty a bond market, and sterling is too far down the list of reserve currencies, to absorb nasty shocks.
Trump comes into this already uneasy picture because of his own lavish borrowing and spending plans. For a few months now, long-term borrowing costs everywhere from Japan to the UK and the US have shown that investors are getting fed up with being used by governments as a low-cost cash machine.
We saw back in January that rising US government bond yields pull up the rest of the market with them. If the US president keeps on needling the longer-term portion of the market, as he has been of late, then borrowing costs will keep rising all over the world, including in the UK, leaving Reeves with even less room for manoeuvre.
“A fiscal crisis now appears to be on the horizon unless tough decisions (such as tax rises) are enacted,” said Neil Mehta, a portfolio manager at RBC BlueBay Asset Management. “Markets will be on high alert over the next months.”
What can break this curse and avert this ugly outcome for Reeves? Investors say the answer is vision and credibility. They don’t honestly care much who is chancellor as long as the plan makes sense, and they have no patience for shambolic policymaking. “It was a rebellion against the lack of discipline over the path forward,” said Sonja Laud, chief investment officer at Legal & General’s asset management division. “Why do you invest? Because you believe [there is] a plausible growth strategy.”
Germany, for instance, is able to draw investors into its long-term debt because it is selling a good reason for finally taking the brakes off its stringent fiscal policy. The UK does not have the same starting point or the same luxury, so for investors, it needs a much stronger narrative. “The psychology here is trust,” said Laud. “It’s not the policy, it’s the fact that you are undermining yourself.”
For markets, swapping out Reeves for an alternative chancellor would probably make little positive difference, assuming the on-again-off-again policymaking endured. It could make matters much worse, if a newbie misspoke or otherwise angered the bond market overlords. Vibes and messaging should not matter to markets as much as cold, hard economic data, but they do. Time is short for Reeves and Starmer to somehow win confidence back, both on the trading floors and on the backbenches.