UK Gilts

British government bonds plunged on Wednesday after the Labour government scrapped planned welfare cuts.

The U-turn, which ditched billions of pounds worth of savings to consolidate public finances, sent shockwaves through the markets and revived fears of the 2022 bond market crash that aborted Liz Truss’ brief premiership.

Chancellor Rachel Reeves fought back the tears during Prime Minister’s Questions today, as she was present alongside Prime Minister Keir Starmer. The appearance, where she appeared tired and tearful, prompted speculation that her days in the Treasury were numbered. While Downing Street later attributed her distress to a “personal matter” and emphasized that Starmer continued to have full confidence in his chancellor, markets were unconvinced.

The yield on the UK 10-year gilt shot up to 4.681% at one stage before Christmas, the biggest intra-day surge since the Truss era mania event. It subsequently moderated to 4.60%, but the die was cast. Yields on 30-year gilts climbed 17 basis points as longer-term fears about fiscal credibility reared their head.

Reeves under fire amid doubts over Labour’s fiscal plan

Chancellor Reeves is in the limelight again over the political fallout from the welfare U-turn. Her fiscal rules are in danger now of being trashed. The benefit cuts that have since been dropped were supposed to buttress those rules by saving the Treasury billions. It has made Britain’s already tight fiscal space even more constrained.

Her leadership is now in question, including from within the Labour Party. There have also been reports that some Labour MPs feel the first raft of cuts was cruel and targeted the most vulnerable. But Reeves had pressured them to help meet her spending goals, a reminder of the tightrope she walks between compassion and credibility.

Starmer’s refusal to say outright that he backs Reeves in Prime Minister’s Questions also added to the speculation. His press office later reiterated their unity, but traders were already selling the news. The pound was down by almost 1% against the dollar and at a two-month low against the euro, which rose 0.8%. The domestically focused FTSE 250 index, which is frequently seen as a barometer of confidence in the domestic economy, fell 1.3%, lagging behind broader European indexes.

“There’s a real fear that if Reeves goes, her replacement could throw out the current fiscal framework,” said Craig Inches, head of rates and cash at Royal London Asset Management. “That would open the door to unbridled borrowing and bring additional instability.”

Even if Reeves stays, the episode has already marred the Labour government’s credibility just weeks in. For much of the financial world, it’s an uneasy beginning.

Global debt fears put pressure on Britain

The UK’s challenges are against a wider background of deepening global concern about government deficits. Bond investors from the United States to Japan are growing wary of soaring government debt. But Britain appears particularly vulnerable.

Unlike other major economies, the UK has little fiscal space, its growth is tepid, and its monetary conditions remain tight. The Bank of England is keeping rates higher to fight inflation, which makes borrowing more expensive for the government and shrinks the fiscal space.

Simon Blundell, head of European fixed income at BlackRock, said the developments had added another layer of uncertainty to an already delicate situation. He noted that while it wasn’t a repeat of 2022, investors remembered what had happened and were quick to react.

While BlackRock has maintained a generally positive stance toward gilts, sentiment could change rapidly if the government fails to send clear, consistent signals about its fiscal intent, according to Blundel.

He added that if spending cuts are politically unworkable and self-imposed rules limit borrowing, the only option left is higher taxes.

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