Having sealed her chancellor’s fate, the markets could seal the prime minister’s fate
So farewell, then, Trussonomics.
The demise of the country’s second shortest-lived chancellor also brings with it the demise of the country’s shortest-lived economic movement.
Liz Truss came into office promising to boost the country’s growth rate through a forensic combination of tax cuts, reforms to the country’s supply side (for which read: things like planning reform) and spending restraint. This was, if you squint a little bit, not dissimilar to the kinds of policies espoused by Ronald Reagan and Margaret Thatcher.
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It always looked risky – especially at such a fragile point for the global economy. We are coming to the end of a 12-year period of cheap money, something which is causing a near-nervous breakdown in financial markets. Central banks are in the process of raising interest rates and trying to feed the glut of bonds they bought during the financial crisis back in the market.
As if that weren’t enough, Europe is facing one of its bleakest economic winters in modern memory, with a war raging in Ukraine and energy prices touching historic highs. It is hard to think of many less auspicious periods to attempt an untested new economic manifesto.
Yet Ms Truss and her former chancellor Kwasi Kwarteng pushed on all the same. And unlike Thatcher, whose first few budgets were grisly austerity packages which no one much enjoyed, Ms Truss and Mr Kwarteng aimed to turn Thatcherism on its head. Instead of fixing the public finances first and then cutting taxes second, they opted to spend the fruits of economic growth before that growth had even been achieved.
The mini-budget of 23 September was a small document with extraordinarily large consequences. Ironically, the more expensive the measures were, the less controversial they turned out to be. The scheme to cap household energy unit costs will potentially cost hundreds of billions of pounds, yet (and we know this because it was pre-announced long before the mini-budget) investors barely batted an eyelid. They carried on lending to this country at more or less the same or equivalent rates.
The same was not the case for the rest of the mini-budget’s policies. Shortly after they were announced – everything from the abolition of the 45p rate (actually quite cheap in fiscal terms) to the cancellation of Rishi Sunak’s corporation tax rise – markets began to lurch in what was, for Ms Truss, and most UK households, the wrong direction. The pound sank, the yields on government debt, which determine the interest rates across most of the economy, began to climb.
That was bad enough. When Mr Kwarteng announced gleefully a couple of days later on television that he had more tax cuts up his sleeve, the trot out of the country became a stampede. The pound fell, briefly, to the lowest level against the dollar in the history of, well, the dollar.
Even more worryingly, those interest rates on government bonds rose at an unprecedented rate, causing all sorts of malfunctions throughout the money markets.
The most obvious – and the one that perhaps will have the longest legacy – is the rise in mortgage rates. But the unexpected consequences were even more worrying, among them a crisis in funds used by pension schemes. That sparked a “run dynamic” which compelled the Bank of England to step in with an emergency support scheme.
Even at this point, we were into unprecedented territory. Never before had the Bank been forced to intervene quite like this. Never before had it had to do so as a result of a government’s Budget.
The intervention, however, had some success, bringing down the relevant interest rates and bringing markets back from the edge. But there was a sting in the tail: a deadline. Today, 14 October.
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Analysis: PM’s new tax U-turn
In hindsight perhaps it’s obvious that this, then, would always have been the day when the government might face another existential crisis. Investors were always going to be nervous ahead of the Bank’s withdrawal from this neck of the bond market. And that is precisely what happened: after the governor reiterated, on a panel in Washington, that he was indeed serious, all eyes then turned to the chancellor. Could he say something to reassure markets?
In the event, the answer was: no. But something else changed matters: growing rumours of a U-turn. That brings us to this morning. The chancellor, pulled back from Washington early, was dismissed. The U-turn began. The corporation tax freeze is to be abandoned. The coming medium-term fiscal plan will involve austerity and a big dose of fiscal pain. The upshot is that Trussonomics, which was hinged clearly on tax cuts like these, is dead in the water.
However, the bigger question concerns what happens next. Those markets, which Ms Truss said explicitly were the reason for her U-turn, are still pretty frantic. No one knows how they’ll fare on Monday, but, whether right or wrong, another grisly day will almost certainly be seen as a sign of the government’s failure. And, having sealed the fate of her chancellor, the markets could well seal the fate of the prime minister.
But that’s a few days away – a long time in both politics and markets.
Liz Truss appoints Jeremy Hunt as chancellor. Pic: Andrew Parsons / No 10 Downing Street
In the meantime, here is something to dwell on: an alternative version of history. In a parallel universe, Ms Truss and Mr Kwarteng did things slightly less hastily. They decided their emergency Budget would simply deal with the energy price shock coming this winter. They promised an OBR statement and hatched plans for a growth-generating budget in a few months’ time.
In that parallel universe, interest rates probably wouldn’t have risen so high. The rises would, anyway, have been blamed on the Bank of England, not the government. The government would have enjoyed some kudos for having prevented energy-related penury this winter and made merry in their honeymoon. Things could have been oh-so different.
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Now, all of this is of course imponderable. But it does rather underline an important point: none of this was inevitable. This wasn’t a crisis like 1992 – where the UK faced monetary pressures suffered by nearly every other nation in Europe. It was simply a succession of very unfortunate decisions at precisely the wrong moment.
At a time of market turmoil and war in Europe, Ms Truss and Mr Kwarteng chose to take a gamble. It did not pay off.
:: The new chancellor, Jeremy Hunt, will talk to Sky News tomorrow morning. Tune in from 7am on Saturday.
The chancellor is under pressure because financial market moves have pushed up the cost of government borrowing, putting Rachel Reeves’ economic plans in peril.
So what’s going on, and should we be worried?
What is a bond?
UK Treasury bonds, known as gilts because they used to literally have gold edges, are the mechanism by which the state borrows money from investors.
They pay a fixed annual return, known as a coupon, to the lender over a fixed period – five, 10 and 30 years are common durations – and are traded on international markets, which means their value changes even as the return remains fixed.
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That means their true interest rate is measured by the ‘yield’, which is calculated by dividing the annual return by the current price. So when bond prices fall, the yield – the effective interest rate – goes up.
And for the last three months, markets have been selling off UK bonds, pushing borrowing costs higher. This week the yield on 30-year gilts reached its highest level since 1998 at 5.37%, and 10-year gilts briefly hit a level last seen after the financial crisis, sparking jitters in markets and in Westminster.
Why are investors selling UK bonds?
Bond markets are influenced by many factors but the primary domestic pressure is the prospect of persistent inflation, with interest rates staying high for longer as a consequence.
Higher inflation reduces the purchasing power of the coupon, and higher interest rates make the bond less competitive because investors can now buy bonds paying a higher rate. Both of which apply in the UK.
Inflation remains higher than the Bank of England‘s 2% target and many large companies are warning of further price rises as tax and wage rises bite in the spring.
As a result, the Bank is now expected to cut rates only twice this year, as opposed to the four reductions priced in by markets as recently as November.
Nor is there much optimism that the economic growth promised by the chancellor will save the day in the short term, with business groups warning investment will be tempered by taxes.
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Sky News’ Ed Conway on the impact of increased long-term borrowing costs as they hit their highest level in the UK since 1998
Is the UK alone?
No. Bond markets are international and in recent months the primary influence has been rising borrowing costs in the US, triggered by Donald Trump’s re-election and the assumption that tariffs and other policies will be inflationary.
The UK is not immune from those forces, and other European nations including Germany and France, facing their own political gyrations, have seen costs rise too. (The US influence could yet increase if strong labour market figures on Friday reinforce the sense that rates will remain high).
But there are specific domestic factors, particularly the prospect of stagflation. The UK is also more reliant on overseas investors than other G7 nations, which means the markets really matter.
Why does it matter to Reeves?
The cost of borrowing affects not just the issuance of new debt but the price of maintaining existing loans, and it matters because these higher costs could erode the “headroom” Ms Reeves left herself in her budget.
Headroom is a measure of how much slack she has against her self-imposed fiscal rule, itself intended to reassure markets that the UK is a stable location for investment, to fund day-to-day spending entirely from tax revenue by 2029-30.
At the budget, she had just £9.9bn of headroom and some analysts estimate market pressure has eroded all but £1bn of that.
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At the end of March the Office for Budget Responsibility will provide an update on the fiscal position and market conditions could change before then, but if they don’t then Ms Reeves may have to rewrite her plans.
The Treasury this week described the fiscal rules as “non-negotiable”, which leaves a choice between raising taxes or, more likely, cutting costs to make the numbers add up.
Why does it matter to the rest of us?
Persistently higher rates could push up consumer debt costs, increasing the burden of mortgages and other loans. Beyond that, the state of the economy matters to all of us.
The underlying challenges – persistent inflation, stagnant growth, worse productivity, ailing public services – are fundamental, and Labour has promised to address them.
Investment in infrastructure and new industries, spurred by planning and financial market reform, are all promised as medium-term solutions to the structural challenges. But politics, like financial markets, is a short-term business, and Ms Reeves could do with some relief, starting with helpful inflation and growth figures due next week.
An intervention by the chancellor to help shore up flagging financial market confidence in the UK economy has been ruled out by the government, amid further declines in the value of the pound.
Sterling fell to its lowest level against the dollar since November 2023 early on Thursday, building on recent losses.
A toxic cocktail of concerns include budget-linked flatlining growth, rising unemployment and the effects of elevated interest rates to help keep a lid on rising inflation.
They have also been borne out by a leap in UK long term borrowing costs, which hit levels not seen since 1998 earlier this week.
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It piles pressure on the chancellor because it signals that investors are demanding greater rewards in return for holding UK debt, adding unwelcome costs to Ms Reeves who is borrowing money to invest in public services in addition to the budget tax burden on business and the wealthy.
The Tories were granted an urgent question in the Commons this morning which urged her to account for the shift in the market reaction to her budget, which critics have warned will only harm investment, jobs, pay and lead to higher prices.
Treasury minister Darren Jones, who was sent to reply on her behalf, told MPs there were no plans for further commentary beyond a Treasury statement issued on Wednesday which defended the government’s approach.
Shadow chancellor Mel Stride urged Ms Reeves to cancel her forthcoming, and long-planned, trade trip to China to allow for a change of course to recover market confidence.
He claimed Britons are having to “pay the price for yet another socialist government taxing and spending their way into trouble”.
Mr Jones responded that he would take no lessons on managing the economy from the Conservatives.
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Why is Rachel Reeves flying to China?
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Liberal Democrat leader Ed Davey demanded an emergency fiscal statement to parliament that cancelled the National Insurance hike planned for April to boost economic growth and bring interest rates down.
In addition to the strain on sterling over Mr Reeves’s tax and spending plans, the effect on the pound has been intensified by a strengthening dollar due to shifting market expectations of fewer US interest rate cuts this year.
Sterling is trading at $1.22 – a level last seen in November 2023.
The spot rate had stood as high as $1.34 in September.
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Investors ‘losing confidence’ in UK
It has also fallen sharply however against other countries’ currencies.
The pound is a cent down versus the euro at €1.19 on the start of the week, falling six tenths of a cent in today’s market moves.
Long-term bond yields, which reflect perceived risk, hit their highest level since 1998 this week and other benchmark gilt yields are heading north too.
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Cost of public borrowing at 26-year high
Additional borrowing costs make it more expensive for Rachel Reeves to service the debt she is taking on.
It may mean she faces a choice between more tax rises – something she had previously ruled out – or spending cuts as higher borrowing costs take their toll.
The Treasury said in its statement: “No one should be under any doubt that meeting the fiscal rules is non-negotiable and the Government will have an iron grip on the public finances,”
“UK debt is the second lowest in the G7 and only the OBR’s forecast can accurately predict how much headroom the government has – anything else is pure speculation.
“Kick-starting economic growth is the number one mission of this Government as we deliver on our Plan for Change. Over the coming weeks and months, the Chancellor will leave no stone unturned in her determination to deliver economic growth and fight for working people.”
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But Matthew Ryan, head of market strategy at global financial services firm Ebury, said of the market moves: “This is a damning indictment of Labour’s fiscal policies, particularly the hike to employer NI (National Insurance) contributions, which businesses have already warned will lead to higher prices and a worsening in labour market conditions.
“We see wide ranging repercussions of this bond market sell-off. On the one hand, weak demand for UK debt raises the risk of either government spending cuts or further tax hikes to balance the country’s finances, neither of which would be positive for growth.
“Elevated gilt yields are also likely to be reflected in higher mortgage rates, which would provide a further squeeze on household disposable incomes.
“These worries have placed a high premium on UK assets, and we would not rule out additional downside for sterling as a result.”
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