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Gilt investors have told the UK Labor government they may need to raise taxes further if they want to retain credibility in the bond market after borrowing costs rose to their highest since the financial crisis.
Chancellor Rachel Reeves has vowed not to repeat October’s £40bn budget tax hike, which many businesses say has acted as a drag on economic activity. But several bond market participants warned that the British government may have to look to taxes to shore up its finances after losing room to maneuver under its self-imposed fiscal rules.
Mahmood Pradhan, head of global macroeconomics at the Amundi Investment Institute, said the UK government “shouldn’t worry about ruling out a tax increase” and that “promises to limit spending alone may not be enough to convince markets”.
A punishing few months in global bond markets, fueled in part by anticipation of US President-elect Donald Trump’s inflationary policies, pushed the UK 10-year bond yield to a 16-year high and erased the government’s wiggle room against its fiscal rules.
On Tuesday, Reeves told parliament she was “absolutely committed” to sticking to her fiscal rules while deflecting questions from MPs about whether she would be forced to cut public spending.
New tax increases would be politically toxic and further undermine Reeves’ political standing.
U.K. 10-year bond yields rose from 3.75 percent in mid-September to a 16-year high of 4.93 percent last week, as a global bond selloff mixed with investor concerns that the U.K. economy is entering a period of stagflation — where persistent price pressures are limiting the Bank of England from cutting rates to support the ailing economy.
Ranjiv Mann, senior portfolio manager at Allianz Global Investors, said a further rise in yields would “increase pressure on the government to take steps to address the budget deficit in March rather than waiting for the budget in the autumn”.
The government could take “corrective measures”, Mann said, such as actually reducing spending in so-called vulnerable departments such as local government or extending the freeze on income tax thresholds beyond 2028.
Robert Tipp, head of global bonds at asset manager PGIM, said he thought the UK government could be forced by market movements to “relax” its tax stance, rather than relying on spending restrictions. “It’s a classic example of where hope would be a bad strategy,” he added.
Peder Beck-Friis, an economist at bond giant Pimco, said it was becoming increasingly likely that the British government would have to deal with its deteriorating 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 warned, that if the government does not introduce further fiscal tightening, gilts will continue to sell off as investors build more and more.fiscal risk premium” into debt.
Reeves stressed on Tuesday that global factors were driving bond markets around the world and reiterated her pledge to have just one budget a year.
The Government Budget Office should provide updated economic and fiscal forecasts on March 26.
Recent gains in bond yields, if sustained, would be enough to more than wipe out the £9.9 billion of fiscal space Reeves left herself in the October budget. Some economists also expect the OBR to cut its growth forecast for 2025 from the current forecast of 2 per cent published in October.
A cut to long-term growth forecasts would further hit the chancellor’s budget space, adding to her fiscal challenges.
Robert Dishner, senior portfolio manager at Neuberger Berman, said the government could consider adjusting policies such as increasing employers’ national insurance costs to reduce its inflationary effect, and even consider commissioning an external audit of the effectiveness of government spending.
“Are there any extra costs? The government can probably find some savings here or there.”
A Treasury spokesman said: “This government’s commitment to fiscal rules and sound public finances is non-negotiable. The chancellor has already indicated that tough spending decisions will be made and a spending review to stamp out waste is underway.”
Additional reporting by George Parker
