The bond markets could force Rachel Reeves to deliver a second budget if investors are disappointed by the chancellor’s fiscal plans next week, a City investor has warned.
David Zahn, the head of European fixed income at Franklin Templeton, said the biggest risk from the budget on 26 November was that Reeves “disappoints”, leading to a sharp rise in bond yields – the interest rate on UK government debt.
In that scenario “it forces her hand to do a secondary budget”, Zahn told reporters in London. “It depends how the bond market reacts. If the bond market reacts very badly … the government will have to react if bond yields start to go up too much,” he explained.
Zahn suggested that it would be “unsustainable” if the yield, or interest rate, on either 10-year or 30-year UK bonds reached 6%. Such high interest rates created a “death spiral”, he warned, meaning the government would hopefully act before yields rose that high.
UK 30-year bond yields are currently 5.35%. Back in early September they hit a 27-year high of almost 5.75%. Ten-year bond yields are trading at around 4.53%.
Franklin Templeton, a California-based asset manager, has $1.69trn (£1.29trn) of assets under management.
Zahn fears that the Labour government’s inability to push through spending cuts means bond investors are unlikely to give the budget a warm welcome, so probably will not push down borrowing costs by buying more gilts (bond yields fall when prices rise).
“If [Reeves is] not going to tackle any of the big taxes, I don’t see what she can do that the market will go ‘fantastic, you fixed it’, because she’s not doing any spending cuts,” said Zahn, who argued that a package of spending cuts and “real tax increases” would bring down gilt yields, and help the government’s funding needs.
Last Friday, there was a sell-off in government bonds after it emerged that Reeves had ditched plans for a manifesto-busting increase in income tax at next week’s autumn budget.
“If she had done income tax, I think markets would have taken that very well. It would have said, OK, we have somebody who’s serious about getting the budget balanced,” Zahn said.
Instead of raising income tax, Reeves is now expected to freeze tax thresholds at the budget, which the Dutch bank ING estimates would bring in £10bn a year as more workers fall into higher tax brackets as their wages rise. She could also raise a plethora of smaller taxes, reports suggest.
City investors are hopeful that the chancellor will create more fiscal headroom for herself in the budget, to help the government keep within its fiscal rule to have debt falling in five years’ time.
Reeves had previously left herself just £10bn of headroom, which is thought to have been eaten up by an expected downgrade to the UK’s predicted trend productivity growth rate. Such limited headroom left the Treasury particularly vulnerable to moves in the bond market or economic changes.
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Zahn suggested that the markets would like to see Reeves give herself headroom “north of £20bn” at this month’s budget. But he also fears that any tax rises are likely to be repeated in a year’s time, predicting: “I do think this is going to be repeated next year, I don’t think this is a one-off.”
“She probably won’t be back next year, but somebody will be back in that seat. They’ll be back next year,” Zahn forecast.
James Smith, ING’s developed markets economist, believes that any spike in bond yields after the budget is likely to be driven by political factors.
“The ruling Labour party’s poll ratings have fallen through 2025, and prime minister Keir Starmer is coming under mounting pressure within his party, not helped by recent communications missteps,” Smith told clients. “Were a leadership challenge to become a more imminent possibility – which at the moment, it’s not – then markets may quickly assume that a new PM would mean a new chancellor. And a new chancellor, perhaps more left-leaning … would be seen as more likely to change the fiscal rules and increase borrowing.”
The Liz Truss mini-budget crisis of 2022 had not helped, said Michael Browne, a global investment strategist at the Franklin Templeton Institute, who warned that it reverberated to this day on both sides of the political divide.
“The markets are not forgetting that either. It can see the opportunity set in the UK. Get it right, and this is really interesting. This is exciting, both from a bond and an equity point of view. But at this point in time, what’s the evidence that suggests we’ll do anything more than muddle through? And muddling through comes with risks,” he said.
