Good morning. Last week, crisis turned to chaos in Westminster, as a Labour leadership contest kicked off, then sort of didn’t. At the same time, the cost of UK government borrowing sky-rocketed. By Friday, 30-year gilt yields on UK government bonds – in essence, the rate of interest the government pays on new borrowing – hit 5.85%, a near three decade high. These figures will probably rise again this week, as further drama unfolds. Despite fluctuations, the long-term upward trajectory is undeniable.
Dominant thinking in the centre of British politics dictates the bond market needs to be appeased. Brief spikes during moments of political unrest might be unavoidable, but spooking investors with radical economic reform à la Liz Truss is considered catastrophic. This attitude has defined Keir Starmer and Rachel Reeves’s faltering tenure.
But there’s a growing rumble of discontent from within Labour’s ranks at this received wisdom. Last year, Manchester mayor and Labour leadership hopeful Andy Burnham admonished Starmer’s government for being “in hock to the bond markets”, (before swiftly backtracking). Last week, MP Paula Barker suggested “the markets will have to fall into line” should Labour’s next leader opt for a more progressive economic agenda, and Clive Lewis has written an essay-length X post on the subject.
For today’s First Edition, I spoke to Daniela Gabor, Professor of economics at Soas, University of London. We discussed how the bond market works, and the case for radical reform. First, this morning’s headlines.
Five big stories
- UK politics | The UK’s next ambassador to Japan could be called to give evidence over the decision to award Peter Mandelson security clearance against the advice of vetting officials.
- UK news | More than 100 new datacentres in the UK plan to burn gas to generate electricity, some potentially doing so permanently.
- World news | An Ebola outbreak in the Democratic Republic of the Congo and Uganda is a “public health emergency of international concern”, the World Health Organization has said.
- UK politics | Andy Burnham faces a perilous race to win the Makerfield seat, his allies have said, as he gears up to fight a byelection that could decide the long-term future of Labour and the country.
- Middle East | The United Arab Emirates has blamed a fire near its nuclear power plant on a drone launched by Iran or one of its proxies, in what the UAE called a “dangerous escalation”.
In depth: ‘Austerity is hardwired to be at the top of the bondholder wishlist’
It’s clear there’s no end in sight to Britain’s already decade-long stretch of political instability. The country never recovered from the 2008 financial crash, thanks to Osborne and Cameron’s unrelenting austerity; we’re still dealing with the fallout from Brexit; a sixth change of prime minister in just seven years is all but inevitable; there was that Liz Truss mini budget; and internationally, warfare, strongmen and the climate crisis add to pressure on public finances.
While the economy stumbles, the state must continue to function, and when governments want to spend more than they can raise in revenue, they borrow. This is done through the issuing of debts known as bonds, or gilts in the UK. On Friday, the 10-year gilt yield – the benchmark for government bonds – climbed above 5.18%, a level last hit in 2008, during the global financial crisis. For context, during the late 2010s, this figure hovered about 1%, and was still below 2% in 2022.
“Basically, if the cost of borrowing increases,” says Gabor, “governments have to dedicate a lot more revenue to servicing their debt.” Every year, the UK now spends more than £100bn on debt interest. Our debt-to-GDP ratio is 94%. By comparison, Germany’s is 64%, and the Netherlands 44%, though Spain, France and the United States are all more than 100%. But, the UK has the highest borrowing costs of any G7 nation. In Japan, rates hover at 2.5%, and in Germany 3%. Italy, France and Canada are all under the 4% mark, while the US is about 4.5%.
Currently, government data shows that British insurance corporations and pension funds hold about 20% of existing gilts, and another 15% are with other British financial institutions such as hedge funds. British banks hold a further 5%, while foreign investors hold about 35%. The Bank of England holds about 20%.
The bond vigilantes
Since taking up office in 2024, Keir Starmer and Rachel Reeves have prioritised “stability and moderation” in government. In the end, this incremental approach to change looks to have spelled their downfall, with both left and right blaming the recent electoral drubbing on the lack of visible progress.
But Gabor argues reshuffling personnel alone won’t rectify this problem. Bond markets don’t only respond to brief moments of political uncertainty, they react to signals of shifting economic priorities and policies. Behind these moves are investors – people – protesting action they perceive to be irresponsible, reducing the security of their investment. The whole purpose of bonds for investors, after all, is to provide “high-quality collateral” – a secure place to put their money.
When those investors sell their bonds, the cost of government borrowing increases. “We call them bond vigilantes,” says Gabor. “Men and women in suits in front of screens, looking at fiscal plans and policy trajectories across the world. Through investment, they offer their stamp of approval – or lack of it – to fiscal decisions.”
Gabor’s view is that these bond-buyers aren’t independent soothsayers, but skin-in-the-game financial actors. Banks, pension funds and private equity have their own profit agendas. “In fact, honest bond investors recognise the structural preference of many bond vigilantes for governments to be fiscally conservative,” says Gabor. “It’s how they get the best returns. Bond vigilantes don’t like fiscal policies that generate growth through spending as it affects their short-term profitability [due to inflation].” In essence, austerity is hardwired to be at the top of the bondholder wishlist.
A choiceless democracy
Even in last week’s reset speech, an attempt to resurrect his premiership, Starmer was accused of being too incrementalist. Gabor believes this is a problem far bigger than the moribund PM: it’s woven into the system. While it can’t account for his many mistakes in government – the many U-turns, the appointment of Peter Mandelson – it does restrict the ability of Starmer, and any successor, to take bolder economic action.
“You end up in what the late Malawian economist Thandika Mkandawire labelled ‘choiceless democracies’,” says Gabor. “If whichever government you vote for concedes to the power of the bond market, nothing transformative can happen. If you simply always follow what bondholders dictate, you cannot do progressive politics or implement progressive economic policies.” When liberal governments seem powerless to implement change, struggling people often turn to radical parties of the right, promising something different.
It might seem counterintuitive, but Gabor believes, “the best compliment a government can get from the bond market is a mild sell-off”. In essence, she argues, we misunderstand how bond vigilantes work. “Actors in the bond market have an incentive to produce returns – the government mission is to produce growth. They have different goals – bondholders and chancellors are frenemies at best.”
Taking back control … of monetary policy
So what can governments do to shore up bond markets while increasing spending? One option is to take more control over monetary policy.
“Five years ago, the Bank of England held nearly 35% of gilts,” says Gabor. “Since 2022, the Bank has been a net seller. It is unique in the way it has done this, selling bonds before they mature rather than waiting for the government to pay its debts on expiry.” Often, these bonds are worth much less than they were originally bought for.
Meanwhile, an Osborne-era agreement between the Treasury and the Bank means the UK government is liable for losses made by the Bank on bonds. The US Federal Reserve and the European Central Bank simply record these losses on the central bank’s balance sheet, to be paid down by future profit. The New Economics Foundation suggests moving to this system could free up to £26bn a year for the Treasury.
Plus, the UK is a global outlier in its heavy usage of bonds which guarantees investor returns in line with inflation. In fact, if it wanted to, the Bank could even opt to wipe the UK government debt it holds in bonds. But government has no control over that – in 1997, Gordon Brown made the Bank of England independent from government. Only, central bank independence does not mean central bank neutrality.
“There is no theoretical reason for the Bank of England to sell bonds at a loss,” Gabor says. “It is a political and ideological choice.” She points to Liz Truss’s much-maligned mini-budget disaster in 2022. It was the spike in the bond market, after all, which toppled Truss, forcing a U-turn on her proposed £45bn in unfunded tax cuts, and her swift ejection from office.
“We have to get rid of the narrative that Liz Truss proved you cannot fight the bond market,” Gabor says. “The Bank of England has a responsibility to be a market-maker of last resort.” In simple terms, to buy up government bonds during periods of significant financial pressure, feeding demand and reducing rates.
“It did not do that in 2022. Some have labelled this inaction a soft-coup; Andrew Bailey left Truss out to hang.” It’s something Bailey denies – and the decision not to get involved was supported by the Guardian at the time. But Gabor is unconvinced. “Whether or not you think her plan was crazy, I do not think technocrats should be making decisions to bring down democratically elected politicians.”
Gabor advocates for a series of further bond market reforms, chief among them changes to force UK pension funds to invest more in gilts. “Not all of these will be easy,” says Gabor, “but the British public no longer wishes to live in an era of moderate incrementalism. From the right and left, the demand is for change.”
