The Labour government appears to want to change the debt rule to allow for more borrowing for investment. There is good reason for this. Without a step-change in productivity, the national debt will triple over the next 50 years, according to the OBR. Better to invest now on key technology and productivity-improving megatrends than sit and wait for the inevitable, so the thinking goes. The Institute for Public Policy Research gave its back on Tuesday to the government ditching the rule that requires debt to fall between years 4 and 5 of the forecast. 

The bond market may not let them. The 10yr gilt yield has risen from around the 3.75% mark in mid-September to close to 4.2% today, whilst spreads have widened. For example, UK-German spreads are at the widest since August 2023. 

Chart source: Bloomberg

The spread with US debt has also moved significantly – UK benchmark 10yr yields were below US yields all year until August but now trade around +20bps from –40bps as recently as April. The respective Fed and BoE arguments about gradual vs aggressive cutting cycles have swirled around a bit, with both central banks oscillating somewhat between more and less dovish positions. And US markets are sensitive to higher debts implied by the spending plans of both presidential candidates. 

Still, the Bank of England is seen cutting a bit more slowly than the ECB, and now the Fed. But it does look as though the threat of more borrowing is exerting an influence on bond investors. Mario Draghi’s competitiveness report – which called for significant investment and even more significantly joint debt issuance – has largely fallen on deaf, if warm, ears. In contrast, it appears Labour are ready to pull the trigger on ‘borrowing to invest’. The question is whether the market is with them on this, and what could be the implication for gilts and sterling. 

Why are gilts moving? 

The government could use the Budget set piece to amend debt rules to free up spending and, implicitly, borrowing. 

It was on September 23rd that the Chancellor, Rachel Reeves, promised the fiscal event of October 30th would be a ‘Budget for investment’. Labour has spent a lot of time, and no small amount of political capital, on showing it will be credible on finances.  

There are various ways this can be done, but it boils down to switching the measure of debt. The manifesto pledged to keep the rule that debt must be falling as a share of the economy by the fifth year of the forecast.  

For example, this could mean switching from the last government’s target of public sector net debt excluding the Bank of England (PSND ex BoE) to other measures such as public sector net worth (PSNW), or public sector net financial liabilities (PSNFL). We don’t need to go into the specifics of these measures. The IFS has detailed explanations. 

But clearly, changing the rules would get a reaction in the gilt market. It might not lead to a Truss-like event, but rates would be higher. 

Here’s the IFS: (underlining mine) 

Such a large change would also raise questions about the government’s capacity to spend this money well, and about the possible impact on government borrowing costs and interest rates more generally. Previous Treasury modelling suggested that an increase in borrowing of 1% of GDP might increase interest rates by between 50 and 125 basis points, depending on economic conditions. An extra £50 billion of borrowing in 2028–29 (roughly the amount of extra ‘headroom’ provided by a switch to PSNFL) would amount to around 1.6% of GDP. To the extent that the additional investment produced material benefits for the productive potential of the economy, we would expect the impact on interest rates to be smaller. But the point is, additional borrowing on this scale could have a material impact on interest rates. 

 And, importantly, raising investment, and thereby borrowing, is not ipso facto a positive. There is a risk that the government does seek to increase investment but hides behind technical changes – cue a sceptical market. 

Here’s the IFS again: 

“Importantly, if the government wants to relax its debt rule to allow for more borrowing for investment, it is not enough to justify this on the grounds that ‘investment is good’. It also needs to explain why we should be borrowing to pay for it. If the government believes more borrowing is the best – or perhaps even the only – way to get to net zero emissions and that failure to do so would be more costly than a rising debt path, it should make the case for this explicitly, rather than hiding behind a ‘technical’ change. If the government is confident that extra borrowing for investment would be sufficiently growth-enhancing to improve long-term fiscal sustainability, it should make that case (to citizens, as well as to gilt market participants). This could be accompanied by a change in the debt rule to signal the logic behind this fiscal strategy, but the crucial thing would be to ensure that the investment funded by that borrowing is – and is widely seen to be – spent well. There are undoubtedly opportunities for productivity-enhancing public investment projects in the UK. Given the UK’s history as a low-investment economy, there may even be some low-hanging fruit. But not all investment is growth-enhancing, and not all of what counts towards measured public investment is in tangible assets (more than 10% of the total is student loans, for example). Making the right choices, and having an institutional framework to make that more likely, is key. And regardless of the precise fiscal rules, debt and debt servicing costs cannot be disregarded entirely. “ 

Arguably the single biggest failure of the Truss mini-Budget was failing to make the case; failing to explain and justify. No OBR forecasts, no offsetting measures. And it was timed very, very badly, just as rates were rising. 

The Labour government may be pushing against an open door of falling rates, but it too runs the risk of failing to explain to the market the economic benefits of, and the reasons for, the extra spending and borrowing. This could get the attention of the bond vigilantes once more. Moreover, in addition to net higher issuance of gilts to pay for the investment, more spending leading to stronger nominal growth could keep inflation higher for longer, leaving gilt yields to push higher still. 

Indeed, already we can see that the bullishness around UK assets in general have dampened amid the autumn downpours. 

Sterling has retreated about 3% against the dollar after running quite aggressively higher to a two-and-a-half-year high; gilt yields have shot higher in the month as discussed, and UK equities have pulled back amid a pre-Budget stumble. Investors pulled a net £666 million out of UK stock funds in September, according to fund tracker Calastone. Consumer confidence has also taken a hit after PM Starmer warned of pain to come. Andrew Bailey said the Bank of England could take a more aggressive approach to cutting rates.  

It’s a risky moment for UK assets, particularly gilts and sterling. The Labour government has a big opportunity; let’s hope they don’t blow it. 

Neil Wilson

Chief Market Analyst at Finalto

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