Sir Robert Stheeman, outgoing head of the UK Debt Management Office has warned that financial investors in government bonds markets might increasingly act to restrain fiscal policy, citing the bond market crisis following Liz Truss and Kwasi Kwarteng’s ‘mini-budget’ in September 2022.
The role of the debt markets and so-called ‘bond vigilantes’ has returned to prominence following the mini-budget. But what are bond vigilantes? And when should (and shouldn’t) policymakers worry about them in relation to government borrowing? This week’s New Economy Brief explores the relationship between bond markets and fiscal policy, and examines what actually happened in financial markets in late 2022.
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Since bond markets reacted badly to the Truss-Kwarteng ‘mini-budget’ in September 2022, there has been a lot of political commentary about the risks of government borrowing. But what actually caused the bond market crisis is still hotly debated, and how we understand it has important political implications. Simon Wren-Lewis puts it best when he says the media often misunderstands financial markets and treats them like “a vengeful god: a powerful but mysterious entity that has the potential to create havoc, and that therefore has to be treated with great respect and offered the occasional sacrifice, like less help insulating homes.” Let's get into it.
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The bond market is a financial market for government debt. When government borrowing rises, the government’s Debt Management Office issues bonds to sell to financial institutions, such as pension funds, in order to finance that debt. Institutions who lend the government money then hold a UK government bond (or ‘gilts’), which allows them to receive interest payments when the government services its debt. These are essentially tradable IOUs from the government, and many investors in UK government bonds are pension funds looking for steady returns on their investment over a long period.
When does the value of bonds change? Bonds are worth more money when the interest rate that they pay out (known as their coupon) is higher than the interest rate on other financial instruments, such as the interest rate on central bank reserves. A bond’s 'yield’ is the rate of return investors receive on their capital (the bond coupon divided by the price of the bond), and the sum of these coupon costs is effectively the government's cost of borrowing. A lot of bonds pay very low interest rates that have been fixed over a number of years - much like a fixed rate mortgage - though many are also tied to the rate of inflation (‘index-linked gilts’).
The role of bond traders. So when traders buy or sell bonds, they are effectively making bets on how interest rates will change over the coming years, just like a prospective house buyer does when they decide between a fixed or variable rate mortgage. Movements in the bond market primarily represent changes in traders’ expectations of how interest rates will change in future. When interest rates are widely expected to fall, bond prices will tend to rise; when they are expected to rise, the opposite happens.
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If bond traders believe government policy might lead to inflation and an increase in interest rates, they will sell UK debt and look for higher-yielding investments elsewhere. As unwanted gilts flood the market, their values fall and their yields rise – so when the government needs to borrow again (either by issuing new bonds or refinancing existing bonds as they mature), it must pay more to do so to attract buyers of the debt. This activity is what people mean by ‘bond vigilantes’: traders expect inflation and higher interest rates will hurt bondholders in future, so they demand more compensation for running those risks – the so-called ‘risk premium’ – and in the process drive up government borrowing costs.
This is what happened during the mini-budget. After winning the Conservative Party’s leadership contest, Liz Truss and Kwasi Kwarteng announced a surprise fiscal event including an additional £45bn per year in tax cuts, funded entirely by borrowing, at a time when the Bank of England was already raising rates to combat inflation. The government bypassed the requirement for the Office for Budget Responsibility to assess how these plans would affect inflation and received criticism from the IMF about their impact. The Bank of England (BoE) announced that it stood ready to raise interest rates in order to bring down inflation and calm financial markets, but the Truss administration criticised the BoE’s independence. This reinforced the loss of confidence in the policy package, compounding the damage by increasing uncertainty about the future path of interest rates.
The BoE’s intervention to save pension funds. UK pension funds immediately felt one of the mini-budget’s knock-on effects. Many funds invest in government bonds, but some also borrow money to buy more bonds and gain extra returns. When government bond values fell, those who had lent this money demanded extra capital as security on the debt. This forced the pension funds to sell bonds to find the money to meet these demands, which drove down the value of bonds even further – this was known as the Liability-Driven Investment (LDI) crisis. The BoE was eventually forced to intervene to stabilise the market (serving as the ‘debt buyer of last resort’) by buying £65bn of government bonds to support their price. (For a helpful explanation of this, watch former bond trader Gary Stevenson’s appearance on Novara Media after the mini-budget.)
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Financial markets reacted badly to all this, which sent government bond values and the pound both plummeting. But there is a debate about exactly what drove bond vigilantes to sell. You often hear that it was increased government borrowing which sparked the crisis, as if traders thought the mini-budget put the UK on track to default on its debt, but this explanation misunderstands how the markets price government debt.
The level of public debt is not correlated with higher bond yields. Looking at long term historical data, BoE Deputy Governor of Monetary Policy Ben Broadbent argued that, while a country's fiscal position does matter and can affect its creditworthiness, it doesn't always directly influence bond yields and borrowing costs. Just like for individuals or companies, if lenders worry that a government might not be able to repay its debts (default risk), they will demand a higher interest rate on new loans to compensate them for running that risk. But governments that increase their borrowing don't always have to pay more to do so. The data suggests that changes in public debt levels aren't the main factor influencing bond yields. Other factors such as expectations about the future path of interest rates and inflation, are more important.
Bond traders did not sell because of concerns about UK debt sustainability. Many investors use the work of credit rating agencies to help them understand the risk that governments will default on their debt. Finance Watch explains that when analysing the likelihood that a country will fail to pay its debts, the agencies look mainly at strong institutions and national wealth, as well as at measures of debt affordability like how much of the government’s revenue is spent on interest payments. But the size of the country’s debt stock, as expressed in its debt-to-GDP ratio, has “no correlation” with its creditworthiness. For instance, Japan has a high credit rating despite a 250% debt-to-GDP ratio. What the funds are used for matters; new borrowing that is productively invested will affect a nation’s credit very differently from debt to finance economic mismanagement. The fact that the UK maintained its double-A rating throughout the mini-budget episode is further evidence that the bond market ‘panic’ wasn’t a reaction to higher public borrowing.
It is not about the size of borrowing; it’s how you use it. IPPR’s Carsten Jung and Carys Roberts concur that “market turmoil was mostly caused by surpassing the short-term inflation constraint” and they “do not think that the market reaction was mainly due to long-term debt sustainability considerations”. This doesn’t mean investors don’t care about debt sustainability, but they do require a credible overall fiscal framework and a strategy to deliver it. The shock repricing of bonds after the mini-budget was due to elevated inflation expectations and doubts about the Truss administration’s growth claims. Contrast this to the bond market’s calm reaction to the much larger borrowing required by the US Inflation Reduction Act, which created jobs and growth, boosted productivity and helped control inflation.
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So although the bond-market meltdown has often been blamed on too much government borrowing, our analysis shows this explanation is far too simple. Bond investors themselves have warned that interpreting the crisis this way would mean we learn the wrong lessons from it.
What are the right lessons? One is that the government can borrow to fund public investment without spooking the bond market – as long as it emphasises that this won’t cause inflation. LSE’s Dimitri Zenghelis and Anna Valero concede that the mini-budget showed that policymakers “have reason to beware the bond market". But they stress the “clear distinction between a programme of unfunded tax cuts (to the order of £45 billion) and the phasing in of an investment programme that can plausibly boost the supply side of the economy”. Simon Wren-Lewis also explains why “the Truss crisis has no relevance to a future Labour government wanting to increase public investment.” Truss and Kwarteng made a mistake big enough to go down in political history. But in the long term, getting the bond market’s reaction so wrong that we starve the UK of desperately needed investment would be an even bigger error.
UK quits the Energy Charter Treaty. The UK has followed France, Germany and others in exiting the controversial Energy Charter Treaty (ECT). The move comes after a long campaign against the treaty, which enables fossil fuel interests to sue countries taking climate action which reduce their future profits. Campaigners Global Justice Now argue that leaving the ECT opens the door for the UK to make a just transition away from fossil fuels.
Unjust transition. The imminent closure of the Grangemouth oil refinery in Scotland is a warning of the perils of an unjust transition, according to a blog from the Working Class Economists Group. While accepting that the refinery “had to close at some point”, author Coll McCail says the way it has been handled is an example of “illogical short-termism”.
Another Jubilee moment. Countries on the frontline of climate change should have their debt forgiven, according to Mia Mottley, the Prime Minister of Barbados. Mottley points out that many small island nations and developing countries are spending more servicing their debt than they are on preparing for the impact of climate change, and argues that the world needed another moment like the 1990s Jubilee campaign.
A climate, energy and development vision for Africa. Power Shift Africa has produced a seminal report on how Africa can harness its vast endowment of clean energy resources and global reserves of key minerals for batteries and hydrogen technologies to achieve renewable energy and food sovereignty and “an afro-centric industrial policy that increases African collaboration and resource control”. This is connected to a growing agenda amongst Global South economic justice activists of ‘delinking’ their economies from the extractive processes which perpetuate global economic inequality.
Net zero and electoral battlegrounds. A report from the Energy Climate and Intelligence Unit (ECIU) on the UK’s £74bn green economy finds that ‘net zero businesses’ support 765,700 full time jobs, many of which are concentrated in some of the most marginal constituencies in the UK: 65% of the top 25 hotspots and half of the top 50 net zero hotspots in England and Wales are classified as battleground seats heading into the general election.
Public priority? Only one in six UK voters want tax cuts if they come at the expense of cutting public services, according to new research from the Fairness Foundation. In a new report, Minority Sport, the Foundation argues that there is “clearly not a public clamour for tax cuts at all costs”, and find that the public support tax reforms like bringing taxes on income from wealth up to the same level as those on income from work.
Unpaid tax. The UK is missing out on £36bn in unpaid taxes from individuals and corporations, according to a joint intervention by businessman Julian Richer and TUC General Secretary Paul Nowak. They argue that HMRC needs more resources to chase unpaid taxes and that such a move is a “no brainer”.
Regional divides. Investing properly in growth outside London and the South East could help rouse the UK from its economic torpor, according to a new paper from researchers at Harvard and King’s College London. The authors (including former Shadow Chancellor Ed Balls) argue that the solution is a UK Growth Plan, proper investment in regional infrastructure and skills, and extending successful devolution models.
