UK’s Biggest Political Parties Tiptoe Around the Bond Vigilantes

(Bloomberg) -- The specter of the UK’s epic market meltdown two years ago is looming large over politicians as Britain prepares to go to the polls on July 4.

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The fear of so-called bond vigilantes — a term coined in the 1980s to describe investors who sold Treasuries to push back against the US government’s largesse — is coloring almost all discussion of Britain’s finances on the campaign trail. From Keir Starmer’s repeated references to the turmoil precipitated by Liz Truss’s unfunded tax cuts, to Rishi Sunak’s push to brand his opponent as an irresponsible tax-and-spender, debt is a near-constant talking point.

Markets appear to be listening.

With less than one month to go, a gauge of UK bond volatility is at the lowest in more than two years. Traders already betting that high interest rates will keep the pound strong are debating whether a Labour government’s EU policies would further boost the currency. Meanwhile, Britain’s stocks — mostly shunned by global investors since the Brexit vote in 2016 — are hovering near record highs.

During the messy leadership transition two years ago, UK bonds plunged the most on record and the pound tumbled to an all-time low, almost toppling the nation’s over-leveraged pension industry.

While no one is predicting a re-run of that maelstrom, which ultimately saw Truss lose her job to Sunak, the market upheaval showed just how quickly a government can lose investors’ confidence. And how carefully they must craft their message to the City.

“They have to keep the market on side,” said Gordon Shannon, a portfolio manager at TwentyFour Asset Management. “They understand that if they stray too far from what’s acceptable, they will be punished quite quickly.”

Lesson Learned

It’s a threat that’s loomed large over generations of politicians.

Governments rely on investors to advance them the capital they need to finance everything from new roads and schools to overseas diplomacy and wars. But that money comes with a catch — bond buyers have to feel they’re getting enough compensation for their loan.

The UK discovered the fragility of this pact first-hand in 2022. While the crisis was exacerbated when some pension funds were forced to sell long-dated debt to meet margin calls — a vulnerability regulators have since tackled by forcing managers to set aside more cash — the episode demonstrated the pain that investors can inflict if policymakers ignore their concerns.

Indeed, BlackRock Inc., the world’s biggest asset manager, warned in January that promises of increased spending ahead of the UK election could ignite a revolt in the bond market.

“The government has to show that it’s fiscally responsible, that it cares about the level of debt,” said James Lynch, an investment manager at Aegon Asset Management in Edinburgh.

But there is some skepticism the next government will meet markets’ expectations. The Institute for Fiscal Studies has said the election campaigns have become a “conspiracy of silence” over the fiscal costs ahead. The think tank’s director, Paul Johnson, said the Labour manifesto will likely “require putting actual resources on the table” and that the Tories’ tax cuts are “paid for by uncertain, unspecific and apparently victimless savings.”

Labour, which is widely expected to win, placed economic stability at the top of its manifesto’s six so-called first steps for change, and described its platform as “built on a rock of fiscal responsibility.”

“If there is one lesson from Liz Truss, it's that if you make unfunded tax cuts then it damages the economy and working people pay the price,” Starmer said at the launch on June 13, an attack that's almost become a mantra for party candidates.

The Tories for their part have stirred controversy with claims about Labour tax increases, which they contrast with their own manifesto pledge to again cut the national insurance payroll levy. Sunak evoked the legacy of Margaret Thatcher to cast his party as one that “believes in sound money” as he unveiled the Conservatives’ platform on June 11.

Both parties have accepted a spending profile for public services that even the head of the Office for Budget Responsibility has called a “fiction.” While they have committed to meet fiscal rules that require the UK’s debt to be falling as a share of gross domestic product in the fifth year of the forecast, neither party has revealed how it would cover the costs to improve crumbling services, like prisons and transport — the International Monetary Fund estimates a £30 billion bill for this alone.

“The fiscal straitjacket they’re left with is pretty tight,” said Luke Hickmore, investment director at abrdn. “There are limited changes any government that wins could make.”

Ballooning Debt

Of course, the UK is not the only country where debt sustainability is a problem, or a campaign issue. Uncertainty over how the US will tackle its mounting debt has investors wary of holding long-dated bonds ahead of the November presidential election. And France — downgraded by S&P Global Ratings in May — is preparing for a snap poll that could determine the nation’s fiscal future.

But with the UK national debt at the highest levels since the 1960s as a percentage of gross domestic product, and the nation already committed to one of its biggest annual borrowing sprees on record, politicians there seem uniquely attuned to the market’s demands for prudence and restraint.

“In this election, the 2022 mini-budget crisis looms very large,” said Karen Ward, chief European market strategist at J.P. Morgan Asset Management. “Then, the bond market said: ‘no, thank you, you can’t spend yourself to growth.’ This time it’s about fiscal prudence and economic stability. We are not expecting July to be a market moving event.”

So reassured are investors by this stance that the pound has barely budged from where it traded immediately before the election was called, and speculative accounts have increased their bullish bets to the highest in two months as of last week. A sale of 10-year gilts on June 11 attracted a record £110 billion of orders — 10 times the amount for sale.

Instead, the Bank of England’s path for interest rates remains the main driver for the UK market — a sign that, in some respects at least, the bond vigilantes have already won.

“The market is holding the whip and the politicians know that they must mind their step, because otherwise they will be hit really hard by another possible crisis,” said Jane Foley, head of FX strategy at Rabobank.

--With assistance from Alice Atkins.

(Updates positioning data in third to last paragraph.)

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