Bond markets could force Rachel Reeves to deliver a second Budget if investors react negatively to next week’s financial plans, a senior City investor has warned, underlining the fragile situation facing the Chancellor ahead of November 26.
David Zahn, head of European fixed income at $1.69 trillion asset manager Franklin Templeton, said the biggest risk for Reeves is that markets “disappoint” rather than celebrate the budget – a scenario that could send British government bond yields sharply higher.
“If the bond market reacts very badly, the government has to react if bond yields rise too much,” Zahn said. “It could force them to create a second budget.” He added that 10- or 30-year British government bond yields of 6% were “unsustainable” and warned of a possible “death spiral” if borrowing costs rose too much.
UK 30-year government bond yields are currently at 5.35%, compared to a 27-year high of almost 5.75% in early September. Ten-year yields are 4.53%.
Zahn said bond investors were unlikely to welcome the budget as the Labor government appeared unable or unwilling to implement spending cuts. This limits the scope for reducing borrowing and limits the likelihood that UK government bond yields will fall.
“If she doesn’t tackle any of the big taxes, I don’t see what she can do to make the market ‘fantastic, you fixed it,'” he said. “She’s not making any spending cuts.”
The warning follows reports that Reeves has abandoned a plan to raise income taxes – a move that Zahn argued “would have been very well received by the markets” as a sign of serious fiscal tightening. Instead, Reeves is expected to freeze tax thresholds, which ING estimates will raise £10 billion a year as the fiscal squeeze pulls more workers into higher tax brackets.
The Chancellor can also impose a range of smaller taxes to raise additional revenue.
Markets will be watching closely to see whether Reeves creates enough fiscal space to meet Labor’s rule of cutting debt within five years. It had previously left itself just £10bn of leeway – a buffer now believed to have been eroded by a downgrade in Britain’s long-term productivity outlook.
Zahn suggested that markets would prefer to see at least £20 billion of headroom in the Budget. He also predicted that more tax increases were likely next year: “I don’t think this is an isolated incident. She probably won’t be back next year, but someone will be.”
Analysts at ING warned that a rise in borrowing costs after the budget was passed could be political, not economic.
James Smith, ING developed markets economist, said falling Labor poll numbers and pressure on Keir Starmer could fuel market speculation about leadership instability: “If a challenge is imminent, markets could assume that a new prime minister would appoint a new, perhaps more left-leaning chancellor – one who is more likely to change budget rules and increase borrowing.”
Michael Browne, global investment strategist at the Franklin Templeton Institute, said the shock of the 2022 Liz Truss mini-budget crisis is still shaping investor behavior.
“The markets don’t forget that either,” he said. “If you get it right, the UK is exciting from a bond and equity perspective. But what evidence is there at this point that we’re going to do anything other than muddle through? And muddling through carries risks.”
