Introduction to Bond Markets
The UK’s bond markets have become a significant factor in British politics, particularly since Liz Truss’s mini-budget. Fears of market instability affecting government plans have become a real concern. The global bond market movements have even triggered Labour’s rushed disability cuts in March. It seems that bond traders, not the government, are in control of the UK.
The Role of the State in Empowering Bond Markets
However, this narrative of all-powerful markets is misleading. The power that bond traders wield is, in part, a gift from the state. The UK’s fiscal framework is hypersensitive to market movements, creating policy uncertainty that fuels market jitters. Uncoordinated fiscal and monetary policy exacerbates these problems. Under Labour, interest rates on government debt have risen higher than during Liz Truss’ mini-budget meltdown, mainly due to the Bank of England and the failed approach to tackling inflation.
The Impact of Interest Rates on Bond Markets
The Bank of England sets the short-term interest rate for the economy, and when the Bank’s base rate is high, the interest rate on government bonds will be too. For longer-term debt, market expectations of the Bank’s rate into the future will impact their interest rates. The Bank has been slow to cut interest rates, creating expectations that interest rates will remain higher for longer. Interest rates are even expected to go back up in the future, likely reflecting expectations that future geopolitical and climate shocks will cause high inflation.
Reducing Expectations and Interest Rates
To lower these expectations — and therefore longer-term interest rates — the government must stop relying on monetary policy as the only tool to tackle inflation. This requires using targeted fiscal measures to address the root causes of price rises, such as intervening in supply chains causing inflationary pressures, strategic price controls, and investment to stabilize prices in particularly volatile sectors, like energy.
The Role of the Bank of England in Bond Markets
The Bank of England’s sales of government bonds as part of quantitative tightening (QT) have increased supply in the bond market by £32.5bn a year on average since 2022–23. Increased supply means, all else being equal, having to attract more buyers of debt who price in higher uncertainty. The Bank estimates this has added 0.15–0.25 percentage points to interest rates on government debt. These higher interest payments translate into an estimated £16bn in extra government costs, with other estimates as high as £60bn.
Reducing Uncertainty in Bond Markets
One way to reduce uncertainty in bond markets could be to allow the chancellor to disagree with the Office for Budget Responsibility (OBR). The OBR is expected to downgrade the UK’s productivity, suddenly creating a "need" for an additional £20bn of savings at the autumn budget. However, the chancellor should be hesitant to react to the OBR’s uncertain data and be wary of its relative pessimism around the positive economic impacts of public investment.
Wider Changes to the Fiscal Framework
We need wider changes to our fiscal framework to respond to other uncertainties. One reason markets reacted positively to rumors that the chancellor would raise income tax is that this is seen as the most credible way to tackle future spending commitments like pensions and the health costs of an aging population. Therefore, requiring the chancellor to look beyond our short-term fiscal rules and develop contingency plans for the long-term would reduce uncertainty.
The Bank of England’s Role in Stabilizing Markets
The Bank of England has the power to stabilize markets, as demonstrated during the pension crisis. The Bank should pledge to do "whatever it takes" to stabilize bond markets if the government decided to borrow more. However, having such a backstop would require stronger coordination between the Bank and Treasury, to ensure extra borrowing is spent on measures that do not go against the Bank’s inflation mandate, and help grow the economy.
Conclusion
The UK government has many options to tame the bond market that do not rely on placating them with yet more austerity. In fact, there is a real risk that austerity would be self-defeating: if it fails to bring debt down, as it did during the Cameron-Osborne era, it will just consolidate the perceived power of the bond markets further. Instead, a better approach to inflation and a rethinking of how the Bank shares losses and conducts QT would help to reduce high interest rates. Further, a fiscal framework that reduces policy volatility, and a proper Bank of England backstop would begin to tackle uncertainty and fluctuations in markets. Reducing the influence of "bond vigilantes" requires a fundamentally different approach to fiscal and monetary policy.
