Britain’s Bond Turmoil Invokes Memory of 1976 Debt Crisis
Philip Aldrick and Greg Ritchie
7 min read
(Bloomberg) -- Britain’s latest bond turmoil has drawn comparisons with the Liz Truss mini-budget debacle of 2022 but a parallel with the debt crisis of the 1970s might be more apt.
That’s the analysis of former Bank of England rate-setter Martin Weale, who said the Labour government may have to resort to austerity to reassure markets that it will address the UK’s escalating debt burden if sentiment does not change.
Over the past few days, long term UK borrowing costs have soared and the pound has fallen – a rare combination that can signal investors have lost faith in the government’s ability to keep a lid on the national debt and control inflation.
Typically, higher yields would support a currency, but Thursday morning sterling sunk below $1.23 to its lowest level since November 2023, having started the year above $1.25. Still, the currency’s latest struggles are less severe than in September 2022, when it crashed from close to $1.17 to below $1.07 in a couple of weeks.
And Britain’s market troubles are not an isolated case, coming amid a global selloff in bonds.
Nevertheless, Weale said the events echo the 1976 debt crisis “nightmare” that forced the government to ask the International Monetary Fund for a bailout. The current surge in debt costs also threatens to wipe out Chancellor of the Exchequer Rachel Reeves’ slim £9.9 billion ($12.2 billion) buffer against her budget rules and create instability ahead of an official fiscal update on March 26.
Other economists and investors blamed the market moves on skepticism around Labour’s promise to fund a large increase in spending with fastest growth.
“We haven’t really seen the toxic combination of a sharp fall in sterling and long-term interest rates going up since 1976. That led to the IMF bailout,” said Weale, now professor of economics at King’s College London, in an interview with Bloomberg. “So far we are not in that position but it must be one of the chancellor’s nightmares.”
Almost half a century ago, Britain applied to the IMF for a $3.9 billion loan after large budget and trade deficits plunged the country into crisis. In return, the government agreed to IMF-imposed austerity. Britain is today running twin deficits again, and has been for many years.
Borrowing Costs
On Wednesday, 10-year government yields jumped as much as 14 basis points to 4.82%, the highest since August 2008. The pound fell against all major currencies, slumping more than 1% versus the dollar, while UK stocks fell.
UK government borrowing costs have risen even faster since the start of the year than in France, which is in political turmoil, is borrowing more and has higher public debt. While the UK still has lower debt than the US, France, Italy and Japan, official data shows its burden is close to 100% of GDP after jumping during the pandemic. The Office for Budget Responsibility expects the deficit to remain high at 4.5% of output in 2024-25 before edging lower in the coming years, though at a slower rate than was expected under the previous government.
Financial market investors said the focus on the UK reflected concerns about how Labour could feasibly deliver its budget plans, which are underpinned by optimistic growth projections, as well as worries about underlying inflation. The BOE has taken a cautious approach to reducing bank rate, wary of loosening too quickly as it expects inflation to rise again to 2.8% later this year.
Weale, now professor of economics at King’s College London, said that if current market conditions worsened, Labour would have little option but cut spending and raise taxes to reassure markets that “the debt was being properly managed.”
Deutsche Bank estimates that the UK’s interest burden in 2029/30 will be £10 billion higher than had been expected when Reeves delivered her budget, while Dan Hanson from Bloomberg Economics puts the added cost from rising yields at about £12 billion.
Several market participants drew parallels with the gilt strike in 2022 after Truss’s chancellor Kwasi Kwarteng announced a series of sweeping tax cuts and spending commitments, but noted that the speed of events is different this time around. Neil Birrell, chief investment officer at Premier Miton Investors, described recent market events as a “slow burning equivalent to what happened around the time of the Liz Truss budget.”
Any similarities were highlighted by an unusual turn of events on Thursday as representatives of Truss wrote to Labour Prime Minister Keir Starmer, urging him to stop accusing her of crashing the economy. In the letter, a copy of which has been seen by Bloomberg, Truss’s lawyers say the claims are false and were made to cause political damage in the run up to last year’s election, in which she lost her seat.
‘It Doesn’t Work’
Regardless of historic comparisons, sketicism appears to have grown around Labour’s plans. Referring to Reeves’ Oct. 30 fiscal event, the second biggest tax-raising budget in UK history, Birrell said: “We’re hitting the point where markets are saying it doesn’t work.”
Mike Riddell, Portfolio Manager at Fidelity International, said the combination of a weaker pound and higher gilt yields had “eerie echoes of August-September 2022, and if this continues, could potentially be evidence of a buyer’s strike or capital flight.”
ING Senior European Rates Strategist Michiel Tukker was less alarmist. He said further sterling weakness “should be limited since this is not a sovereign crisis.”
A Treasury spokesman said its fiscal rules were “non-negotiable and the government will have an iron grip on the public finances.” They added that UK debt is the second lowest in the Group of Seven nations and only the Office for Budget Responsibility — the official fiscal watchdog — could accurately predict the level of headroom. “Anything else is pure speculation.”
The BOE said it is watching markets, as is normal practice.
The market backlash follows weeks of bad economic news. Growth has stalled since Labour’s landslide election victory in July and business sentiment soured since Reeves increased taxes by more than £40 billion. GDP flatlined in the three months to September and may have stagnated through to the end of 2024.
Plans in the budget to borrow an extra £140 billion over the parliament to battle climate change and rebuild public infrastructure also spooked investors as the sum was roughly twice as much as markets expected. Before the budget the IMF said debt risks in the UK were “elevated” and the “lack of credible plans for dealing with it can trigger adverse market reactions.”
‘Painful Sequels’
Reeves’ decision to leave herself the slimmest of buffers against her self-imposed fiscal rule to pay for day-to-day spending out of taxes has added to the market uncertainty and put her credibility at stake, given her pledge to give business clarity by holding just one policy event a year.
Her headroom has now been eliminated, which would force her to come back for either spending cuts or tax rises in March if nothing changes. Officials have indicated she would rather cut spending.
“The forthcoming spring statement, spending review, and autumn budget will likely be painful sequels to the chancellor’s historic inaugural budget,” said Sanjay Raja, chief UK economist at Deutsche Bank.
Weale said the budget problems have been brewing for a long time because successive former Conservative chancellors also failed to address the UK’s escalating debt burden, which is now at its highest level since the early 1960s.
“Policy over the last 20 years has been to let it rise when things go wrong and not offset that when the sun is shining. Perhaps it is surprising that markets may only now be getting concerned about that,” Weale said.
--With assistance from Blaise Robinson, Tom Rees and Claire Ruckin.
(Corrects the spelling of Office for Budget Responsibility.)
