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Gilt investors have told the UK’s Labour government that it may need to increase taxes further if it is to retain credibility with the bond market after its borrowing costs rose to their highest since the financial crisis.
Chancellor Rachel Reeves has promised not to repeat October’s £40bn of Budget tax rises, which many businesses say has acted as a drag on economic activity. But several bond market participants warned that the UK government may need to look to taxes to bolster its finances after losing its room to manoeuvre under its self-imposed fiscal rules.
Mahmood Pradhan, head of global macro at Amundi Investment Institute, said the UK government “should not be boxing itself in by ruling out tax increases” and that “pledges of spending restraint alone may not be sufficient to convince the markets”.
A punishing few months on the global bond markets, partly driven by anticipation of US president-elect Donald Trump’s inflationary policies, have sent UK 10-year bond yields to a 16-year high and has wiped out the government’s wriggle room against its fiscal rules.
On Tuesday, Reeves told Parliament she was “absolutely committed” to sticking to her fiscal rules as she brushed off questions from MPs over whether she would be forced to cut public spending.
New tax increases would be politically toxic and further undermine Reeves’ political position.
The UK’s 10-year bond yields have risen from 3.75 per cent in mid-September to a 16-year high of 4.93 per cent last week, as a global bond sell-off mixes with investor concern that the UK economy is entering a period of stagflation — where persistent price pressures constrain the Bank of England from cutting rates to support a flagging economy.
Ranjiv Mann, senior portfolio manager at Allianz Global Investors, said any further rise in yields would “increase pressure on the government to take steps to address the budget shortfall in March instead of waiting for the Budget in the autumn”.
The government could take “corrective actions”, Mann said, such as a real-terms spending squeeze in so-called unprotected departments such as local government, or extending a freeze in personal income tax thresholds beyond 2028.
Robert Tipp, head of global bonds at asset manager PGIM, said he thought the UK government might be compelled by market movements to “give way” on its tax position, rather than rely on spending curbs. “It’s a classic example where hope would be a bad strategy,” he added.
Peder Beck-Friis, economist at bond giant Pimco, said it was getting increasingly likely that the UK government will need to address its worsened fiscal position.
“We would be very surprised if the government did not adjust tax or spending to meet these fiscal rules . . . we expect the government to maintain fiscal credibility and adjust these variables.”
There is now a risk, investors have warned, that if the government does not come forward with a further fiscal tightening, gilts sell off further as investors build in more of a “fiscal risk premium” into the debt.
Reeves stressed on Tuesday that global factors had been driving bond markets around the world and reiterated her pledge to hold only one Budget a year.
The government’s Office for Budget Responsibility is due to provide updated economic and fiscal forecasts on March 26.
Recent gains in bond yields, if sustained, would be sufficient to more than erase the £9.9bn of fiscal headroom Reeves left herself in her October Budget. Some economists also expect the OBR to downgrade its 2025 growth forecast from the current 2 per cent prediction issued in October.
A reduction to longer-term growth predictions would further hit the chancellor’s budget headroom, adding to her fiscal challenges.
Robert Dishner, senior portfolio manager at Neuberger Berman, said the government could consider tweaking policies such as the rise in employers’ national insurance costs, to reduce its inflationary effect, and even consider commissioning an external review of government spending efficiency.
“Are there excess costs? The government can probably find some savings here or there.”
A Treasury spokesperson said: “This government’s commitment to fiscal rules and sound public finances is non-negotiable. The chancellor has already shown that tough decisions on spending will be taken, with the spending review to root out waste ongoing.”
Additional reporting by George Parker
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