Bond investors are queueing to lend Boris Johnson the billions he wants to level up the regions, despite economists warning the prime minister against opening up the spending taps by ditching his election pledge in next week’s Budget not to borrow to fund day-to-day spending.
The positive mood among the government’s big lenders runs counter to warnings that the prime minister’s administration would lose all credibility on the public finances if it tore up the rules before they were even implemented and face a hefty premium on any new borrowing.
This divergence of opinion leaves Rishi Sunak, the new chancellor, with a dilemma as he prepares to deliver the Budget on March 11. The chancellor said on Sunday that he believed in “the importance of fiscal responsibility”, but officials have refused to be drawn on what this means for the fiscal rules beyond the vague assurance that the government’s plans will be in line with “a fiscal framework”.
The Conservative government is struggling to lift spending across public services, while funding its promise to spend an extra £100bn on infrastructure over the next five years, under its self-imposed fiscal rules.
Mr Sunak must decide whether to stick with the pledge in the party’s election manifesto to balance the current budget so that tax revenues at least match day-to-day spending, limiting the government only to borrow for capital investment.
Despite the dire warning from economists, financial market participants said there would be little negative reaction if this rule was broken.
“I think the market would welcome it,” said Iain Stealey, head of international fixed income at JPMorgan Asset Management. “We have done austerity and it doesn’t work. Monetary stimulus gives asset price inflation but has it helped growth? It’s not really clear it has.”
He said the move would probably lift the government’s borrowing costs slightly, but any rise was likely to be small and shortlived and measured in hundredths of a percentage point. “You are talking about a handful of basis points,” he said.
Investor confidence that UK government would not see a significant rise in its borrowing costs stems in part from very low interest rates around the world. Bond yields around the world, like those of UK gilts, have plummeted to record lows during the coronavirus outbreak Yields fall when the price of bonds rise.
David Zahn, head of European fixed income at Franklin Templeton, said in this climate UK government bonds would attract investors around the world. “If you see gilt yields go up all of a sudden there would be demand from outside the UK.”
Analysts at HSBC predict UK issuance in the 12 months to April 2021 will hit £155bn, an eight-year high. “You could see some underperformance of gilts on a relative basis to other markets,,” said Daniela Russell, HSBC’s head of UK rates strategy, who said buyers would ultimately be influenced by the UK’s wider economic outlook.
Mike Riddell, a fund manager at Allianz Global Investors, said there was no reason why Britain could not run a large deficit as the Bank of England could resort to buying up a large slice of the new debt under so-called quantitative easing.” Even if the UK does end up borrowing much more than expected, if things get sufficiently bad, then the Bank of England cuts rates and does QE.”
Economists do not dispute investors’ views that there is plenty of appetite for gilts but worry that if budget rules are broken so easily, any subsequent constraints will lack credibility and soon the government could lose control of the public finances.
The Institute for Fiscal Studies said last week that abandoning a rule, enshrined in the manifesto, so quickly “would surely undermine any credibility attached to fiscal targets set by this government”.
Thomas Pope, economist at the Institute for Government, added that the point of fiscal rules is not so much to limit borrowing costs but “avoid the temptation to borrow more, leaving future generations to deal with the consequences”.
In the wake of the financial crisis, a massive increase in government borrowing was accompanied by tumbling bond yields as the BoE launched a programme of asset purchases. Robert Stheeman, who heads the UK’s debt management office, told the FT in January he is “very confident” about the market’s ability to absorb another big rise in gilt issuance.
Although the size of the UKs debt has continued to rise, low interest rates make it cheap to service. The government paid £38.5bn in interest in the 2018-19 fiscal year, the lowest level relative to the size of the economy since 2003-04 at 1.8 per cent of GDP.
There are some dissenting voices on both sides, however. Some fund managers anticipate a sharper rise in yields. “I think the market is not priced for any substantial fiscal easing — especially given the current government’s stance — so, if fiscal stimulus were to be delivered, it could have a big impact on markets,” said Scott Thiel, chief fixed-income strategist at the BlackRock Investment Institute.
In contrast, Martin Beck, UK economist at Oxford Economics, said a change to the current budget balance rule, “wouldn’t bring the roof down”.
In fact, investors said any lasting rise in borrowing costs would probably reflect growing confidence in the UK economy at home and abroad which could drive the BoE and other central banks to raise rates, rather than a sign of worries over debt sustainability.
“A move up in yields would be a sign of success, not failure,” said Mark Dowding, chief investment officer at Bluebay Asset Management.