Why have Britain’s bond yields jumped sharply?

Worsening the headache, sterling has tumbled too. That is a rare and toxic mix. In rich countries, bond yields and currencies mostly rise and fall together; juicier yields should lure foreign capital in. Opposing moves are usually a hallmark of emerging markets, where jumpy investors tend to scuttle away at the first sign of trouble. Outside Liz Truss’s brief premiership and calamitous mini-budget in 2022, Britain has rarely seen the past month’s pattern of rising gilt yields and a steep drop in the pound.

The Labour Party won last July’s election after a campaign that missed few opportunities to remind voters of Ms Truss’s 49 disastrous days in Downing Street. Any similarities to her sorry tenure will cause shivers for Labour. The Conservatives have relished the role-reversal; Mel Stride, the shadow chancellor, has accused Labour of “driv[ing] the economy into a ditch". In a surreal turn, Ms Truss has sent Sir Keir Starmer a cease-and-desist letter, threatening legal action if the prime minister continues to accuse her of “crashing the economy".

But unlike October 2022, when Britain’s bond woes were entirely home-grown, today they are mostly imported from America. Treasury yields shot up after Donald Trump’s election win in November, as markets adjusted to his inflationary plans for trade conflict abroad alongside tax cuts and mass deportations at home. His quarrels with the Federal Reserve have unsettled the bond market. That, in turn, has pushed up bond yields around the world. The spread of gilt over Treasury yields is up, but by nowhere near as much as after Ms Truss’s mini-budget (see chart 1).

That doesn’t let the government entirely off the hook. The shudders in sterling suggest that investors have growing doubts about Britain’s fiscal credibility. So does the fact that long-term yields have risen more than short-term ones. Rachel Reeves, the chancellor, raised borrowing by around 1% of GDP in her first budget on October 30th, knocking gilt yields up. Inflation is also proving stickier than expected. That problem predates Labour’s time in charge, but a dose of economic stimulus has hardly helped.

However blame for the sell-off is divided, Ms Reeves is stuck with the consequences. Most immediate, and embarrassing, is the prospect of breaking her own fiscal rules, loosened in the budget. The change helped free the Treasury to borrow tens of billions extra per year, which Ms Reeves used to dial up spending on public services, especially health.

That left only around £10bn ($12bn or so) of leeway, even against the new yardstick. Higher yields mean costlier borrowing and less fiscal headroom. The gilt moves since the budget have left Ms Reeves no space at all, estimates Capital Economics, a consultancy (see chart 2). The Office for Budget Responsibility, the fiscal watchdog, will publish its own assessment, along with broader economic forecasts, on March 26th.

Unless bond yields come down again, Ms Reeves will have to raise taxes (on top of increases in October’s budget), cut spending or breach her fiscal rules—which she has described as “iron-clad" and “non-negotiable". The adjustments needed would probably be small change against the vast scale of government finances, but being forced into them by the bond market scarcely inspires confidence.

More important is the actual hit to the government debt bill. Two-fifths of the rise in government spending since the pandemic is down to higher debt interest. If yields stay high the squeeze will get more painful still. That will mean tax increases or spending cuts down the line.

What can be done? Managing the whims of Mr Trump is far beyond any British government’s power. Keeping a lid on inflation is mainly the Bank of England’s job. What Sir Keir and Ms Reeves can do is keep borrowing in check and focus seriously on raising Britain’s meagre growth rate. To appease the bond market, they will have to do both.