How to tame the bond markets

Panic over bond markets has become a staple of British politics. Since Liz Truss’s mini-budget, fears of markets toppling government plans have become a real possibility. Global bond market movements partly triggered Labour’s rushed disability cuts in March. Keir Starmer said challenges to his leadership would ​“destabilise the financial markets.” It would seem that bond vigilantes, not the government, run the UK.

Yet this narrative of all-powerful markets is misleading. The power that bond traders wield is in part a gift from the state. Our fiscal framework is hypersensitive to market movements, which creates policy uncertainty that then fuels the very market jitters it is there to supposedly prevent. Meanwhile, 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 our failed approach to tackling inflation. The Bank sets the short-term interest rate for the economy, therefore 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 (Figure 1), likely reflecting expectations that future geopolitical and climate shocks will cause high inflation.

Figure 1: Interest rate expectations have risen over time

To lower these expectations — and therefore longer-term interest rates — this 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, like intervening in supply chains causing inflationary pressures, strategic price controls and investment to stabilise prices in particularly volatile sectors, like energy. Moreover, this government should avoid policies that can make inflation stick, which seems to have been the case with the increase to employer national insurance contributions.

Beyond the Bank’s interest rate, bond markets price in premiums for uncertainty. According to a former International Monetary Fund (IMF) chief economist, the UK’s fiscal framework creates ​“excess fiscal policy uncertainty.” Therefore, 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. But 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. The OBR’s undue power over the chancellor’s tax and spending decisions means that tiny adjustments to forecasts can result in kneejerk policy changes.

However, we need wider changes to our fiscal framework to respond to other uncertainties. One reason markets reacted positively to rumours that the chancellor would raise income tax is this is seen as the most credible way to tackle future spending commitments like pensions and the health costs of an ageing population. Therefore, requiring the chancellor to look beyond our short-term fiscal rules and develop contingency plans for the long-term would reduce uncertainty, for example by naming which taxes will rise in line with long-term day-to-day spending. This could give markets confidence that longer-term pressures will be responded to, as opposed to the fiscal rules constantly being changed instead.

Currently, the Bank’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 are as high as £60bn. Furthermore, the Bank makes large losses on these sales – selling bonds for lower prices than it initially bought them – which are then passed onto the Treasury. Covering these losses will cost the Treasury roughly £20bn a year in the next five years.

Figure 2: Bond market supply has increased by large amounts in recent times

Figure 2 shows that from 2024 – 25 onward, the bond market’s holdings of government debt will roughly increase in size by £200bn a year. Yet roughly £30bn of this will be due to QT sales, a practice which other central banks are not currently engaging in. Roughly £20bn more will come from the Treasury covering losses, adding to the government’s need to borrow, even while other central banks instead absorb their own losses. Therefore, bringing the Bank of England more in line with other central banks when it comes to QT and losses could reduce bond market pressures by up to £50bn year. This should be the first port of call for a chancellor looking to make savings.

The pension crisis after Truss’s mini-budget showed that bond markets can be fragile. The overleveraged positions of pension funds leading to a fire sale took many by surprise. The Bank’s offer of only temporary support to buy bonds and stabilise their prices during the crisis may have made bondholders worried about Bank support in future crises. Together, these worries add premiums to bonds and exacerbate market reactions to movements in interest rates.

Yet, as the pension crisis demonstrated, the Bank has the power to stabilise markets. Therefore, it should pledge to do ​“whatever it takes” to stabilise 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. The Bank should also reduce its need to intervene by using its macroprudential powers to regulate finance: firms’ overleveraged financial positions shouldn’t act as a constraint on government borrowing.

This 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. 

Image: HM Treasury Flickr