Standfirst: We set out three potential scenarios the chancellor could follow as she attempts to balance the books, and what each might do to bond yields and markets
On 26 November, the UK chancellor, Rachel Reeves, will again attempt to solve the as-yet unsolvable equation: how to balance the books, keep bond markets appeased, and offer the electorate some economic optimism. It is expected that the chancellor will have to plug a £20-30 billion blackhole in the public finances through a mixture of tax rises and spending cuts. The former won’t win over voters; the latter risks the ire of her own party.
But doing neither and instead attempting to engineer a way out of the blackhole – basically, bending her own fiscal rules to tolerate more borrowing – without any real economic consolidation risks the ire of a more menacing force: the bond vigilantes. The gilt market has been treading on thin ice relative to global peers, which is evident in both volatility and term premia risk dynamics. With some low-level scarring still remaining from Liz Truss’s 2022 ‘fiscal event’, the chancellor ought to be seeking a market-friendly message.
How did it get to this?
In March, the chancellor found around £10 billion of budget headroom versus her most constraining fiscal target – closing the deficit by 2029/30. Since then, however, failed spending cuts and higher yields and inflation have tipped the scales into deficit. There is also the prospect of a downward revision to medium-term growth forecasts from the Office of Budget Responsibility (OBR) that would make a bad situation even worse.
Labour’s huge election majority in 2024 was expected to bring a period of political stability and effective policymaking. But the failure to enact spending controls, such as scrapping the winter fuel allowance or reducing welfare spending, shows the extent of party divisions. Consequently, public opinion of the government has deteriorated significantly, with recent polls showing that Nigel Farage’s Reform UK party would win a general election if one were held tomorrow. As such, this budget isn’t just an exercise in balancing the books, but a hugely politically important event.
Budget scenarios and possible market reaction
Given the competing forces the chancellor must balance, there are several options to tackle the blackhole, each with differing impacts for financial markets. We set out some possible scenarios:
Put up and shut up
This scenario requires the most political courage as it forces the economy to take some painful medicine. The government scraps its manifesto pledge of no tax rises for working people. Given the significant revenue gains from an income tax hike, the chancellor presents a more generous fiscal headroom of £20-40 billion, creating some futureproofing of government finances. Near-term fiscal sustainability concerns are addressed at the expense of consumer and business confidence. The chancellor gambles that any knock-on economic slowdown does not go beyond the OBR’s central growth forecasts, thus avoiding a ‘doom loop’ of economic weakness (fewer tax receipts equals a bigger blackhole to re-address). Labour MPs will be happier to approve tax rises over welfare cuts, even if the tax U-turn costs some political capital.
Possible outcome: Markets prefer decisive action over uncertainty, and raising income tax is a comprehensive measure – overall this is a favourable scenario for gilts, and likely to be a positive surprise for markets. Front-end gilt yields should find support from expectations of further rate cuts as the Bank of England (BoE) looks to counter the impacts of any economic slowdown. Long-end gilts should benefit from both term premium compression and the scope for cooling inflation in a lower growth environment. Overall there isn’t a strong yield curve slope signal from this scenario, but there will likely be a knee-jerk richening of asset swap spreads, ie outperformance of gilts versus swaps.
Keep calm and backload
A more politically tempting scenario: the chancellor engineers a budget that sticks to the fiscal targets, but by way of more borrowing in the near term balanced by sharp fiscal tightening at the end of the target period (2029/30). This approach allows for a good degree of tinkering – some stealth tax (ie a freeze on income tax thresholds), some wealth tax (property, pensions, ISAs), and some fiddling of peripheral tax (targeting gambling firms and landlords etc). The spending side of the equation sees at least some budget freezes for unprotected government departments. Give a thought to the reality of backloaded tax hikes as an election looms.
Possible outcome: Markets are likely to be underwhelmed – this is not a scenario that addresses fiscal sustainability concerns. Instead it would keep the UK in budget groundhog day and would only deteriorate the near-term debt fundamentals for gilts – ie more debt and more issuance supply. As a result, gilt yields are likely to move higher, most intuitively in a bear-steepening trajectory (whereby long-term interest rates rise faster than short-term rates), and cheapening pressure stays on asset swap spreads. If the Treasury responds with even greater front-end issuance there may be some damage limitation on the long end.
Moving the goal posts
So far, tax rises touted in the media and attempts to cut welfare spending have been ‘all pain, no gain’ in terms of public opinion. Here the chancellor instead prioritises politics over economics and delivers a budget composed of no significant spending cuts, targeted wealth taxation (ie not a revenue game-changer) and changes to the fiscal targets to allow more borrowing.
Possible outcome: This is likely to seriously unsettle markets – in less than a year the chancellor is implicitly admitting defeat that fiscal sustainability isn’t achievable for the UK given the political environment. More borrowing combined with less credibility is not only a gilt problem, but is also likely to hit pound sterling. The risk of a ‘stagflationary’ trap would rise, whereby the Bank of England has to contend with higher imported inflation keeping policy rates elevated while the rest of the gilt curve suffers from continued rising term premia. This would see curve steepening intensify, as does asset swap cheapening.
Politicians are usually galvanised by crises – the gilt market stress from this scenario might, in quick order, trigger a deeper more philosophical debate on the nation’s finances. Might it be a Labour government which questions the pension triple-lock or even the scope of NHS provisions? Therein might lie the ultimate salvation for gilts, but that would be a long and bumpy journey.
Conclusion
Given the potentially significant market fallout from scenario three, this is a low probability outcome. Meanwhile, the political environment makes scenario one hard to envisage. Therefore a scenario two budget – with no real change to the status quo – looks inevitable. A nervy gilt market may have to find solace from external factors – lower US Treasury yields, lower global energy costs, reduced trade friction – going into 2026.
For LDI portfolios, a continued focus on healthy liquidity buffers is key amid expectations of patchy gilt volatility. The policy backdrop (fiscal and monetary) is set to keep repo financing costs grinding higher, requiring careful management.
