UK 10-Year Gilt Yield Surges 8.1% On Welfare U-Turn

British government bonds experienced a significant decline on Wednesday following the Labour government's decision to reverse planned welfare cuts. This abrupt change in policy, which involved forgoing billions of pounds in savings aimed at stabilizing public finances, sent ripples through the markets and reignited fears reminiscent of the 2022 bond market crash that led to the downfall of Liz Truss' brief tenure as Prime Minister.

Chancellor Rachel Reeves appeared visibly emotional during Prime Minister’s Questions, standing alongside Prime Minister Keir Starmer. Her distressed demeanor sparked speculation about her future in the Treasury. Although Downing Street attributed her emotional state to a personal matter and affirmed Starmer's continued support for his chancellor, market reactions were less than reassuring. The yield on the UK 10-year gilt surged to 4.681% at one point before Christmas, marking the largest intra-day increase since the tumultuous events of the Truss era. It later settled at 4.60%, but the damage was done. Yields on 30-year gilts also rose by 17 basis points, reflecting growing long-term concerns about fiscal credibility.

Chancellor Reeves is once again under intense scrutiny due to the political repercussions of the welfare U-turn. Her fiscal rules are now under threat, as the benefit cuts that were abandoned were intended to bolster these rules by saving the Treasury billions. This reversal has further tightened Britain's already constrained fiscal space. Reeves' leadership is being questioned, both within and outside the Labour Party. Some Labour MPs have expressed that the initial cuts were harsh and targeted the most vulnerable, despite Reeves' efforts to meet her spending goals, highlighting the delicate balance she must maintain between compassion and fiscal responsibility.

Starmer's reluctance to explicitly endorse Reeves during Prime Minister’s Questions further fueled the speculation. His press office later reaffirmed their unity, but traders had already reacted negatively. The pound depreciated by nearly 1% against the dollar and reached a two-month low against the euro, which appreciated by 0.8%. The FTSE 250 index, often seen as a gauge of confidence in the domestic economy, dropped by 1.3%, underperforming broader European indexes.

Craig Inches, head of rates and cash at Royal London Asset Management, noted, “There’s a real fear that if Reeves goes, her replacement could discard the current fiscal framework. That would pave the way for unrestrained borrowing and further instability.” Even if Reeves remains in her position, the incident has already tarnished the Labour government's credibility just weeks into their term, casting an uneasy shadow over their financial policies.

The UK's fiscal challenges are exacerbated by a broader global concern over government deficits. Bond investors worldwide, from the United States to Japan, are growing increasingly wary of escalating government debt. Britain, however, appears particularly vulnerable due to its limited fiscal space, sluggish growth, and tight monetary conditions. The Bank of England's efforts to combat inflation by maintaining higher interest rates make borrowing more expensive for the government, further constraining fiscal space.

Simon Blundell, head of European fixed income at BlackRock, observed that the recent developments have added another layer of uncertainty to an already fragile situation. While he acknowledged that the current scenario is not a repeat of 2022, investors are quick to react, remembering the past turmoil. BlackRock has generally maintained a positive outlook on gilts, but sentiment could shift rapidly if the government fails to provide clear and consistent signals about its fiscal intentions. Blundell suggested that if spending cuts are politically infeasible and self-imposed rules limit borrowing, the only remaining option is higher taxes.