Peeking through the bullet chamber: why this UK budget is a global litmus test

The three things investors should know this week.

1.???? The UK budget is due to be announced this week. Chancellor Reeves who is called upon to deliver a turn in British finances and better growth prospects, has gone to great lengths to hint her intentions for fiscal expansion to the press, in hopes of reducing the possibility of a market rebuke.

2.???? Overall, DM governments have opted towards fiscal expansion in the past few years. Debt is now at a very high level. Coupled with inflation and interest rate uncertainty, bond markets have become anxious.

3.???? Presently, all major economies play a game of Russian roulette. They fire, pushing their debt limits even further, and hope that the chamber (a market event) is empty.

“O Tempora O Mores!”, Cicero cried in the Roman Senate in 63 BC, as he denounced Catilina for plotting to take down the Republic. “Oh The Times, Oh The Customs”.

With a couple of days to go until the UK budget, Commons Speaker Sir Lindsay Hoyle rebuked new Chancellor Rachel Reeves for discussing the budget with journalists ahead of the House of Commons. Her move breaks with protocol and suggests disrespect for the House. The experienced parliamentarian’s scolding to the rookie Chancellor is probably part of his job, but in the Age of Debt Ms Reeve’s approach of testing the market waters before a big budget (the first labour budget since March 2010) makes absolute sense.

If there’s one thing markets hate more than an expansive budget is a surprisingly expansive budget. Recent history, the cautionary tale of Kwasi Kwarteng’s budget that brought down Liz Truss’s new government in October 2022, explains exactly why big surprises are likely to be “leaked” to markets before brought in the chamber. Since that woeful day, which humbled and brought down a new Prime Minister, budgets have been extremely careful.

Labour has made generous fiscal and at the same time growth promises, that can only be covered by incurring more debt. Hence Ms Reeve’s move to classify student debt as an asset rather than a liability (which may imply that debtors are actually on the hook for it), to gain a ￡50bn space in the budget. Will markets go for it, or will Mr Kwarteng’s story repeat itself? The first step to avoid disaster, is to test the waters. If there’s one thing bond vigilantes hate more than an expansive budget is a surprisingly expansive budget.

It is an acrobatic exercise in accounting, to be sure. But Ms Reeves seems pragmatic enough to understand that the true test of the budget will not be her own party’s MP, with a strong 78-vote majority, or the British Parliament as a whole, or even the Office of Budgetary Responsibility (OBR). Rather it is financial markets. As such, the notion of a sealed box containing surprises for everyone to be presented first in Parliament is not only outdated, but potentially inflammatory for the economy and the yield on His Majesty’s debt.

It is a challenge when a new Chancellor is presenting a budget. An even bigger one when it is on behalf of a completely new government, especially from a party known for fiscal expansion. The level of difficulty is further raised further by the fact that bond markets have been especially jittery in the past few weeks, as traders find themselves in need to readjust their rate expectations for the US, in light of stronger growth data.

The Fed may have erroneously emitted too dovish a signal with the double rate cut in September. It is now trying to double back, but it has already caused much frustration in Financial Markets who have transitioned from casually pricing in a multitude of rate cuts to “not certain anymore”. As a result, global yields have been rising. For the UK, the 10y yield has risen by half a percentage point in just a month and a half, to 4.25%. Global bonds which had risen as much as 3.5% during the year, are now flat.

We live in an era of rapid debt accumulation. Global Debt-to-GDP has risen from 220% to 327% in twenty five years.

Government debt is now the highest portion of that.

France, the Eurozone’s second biggest economy, has long flaunted EU fiscal stability rules now finds itself with higher sovereign spreads than Spain and under warning from Brussels. Markets are also worried about Germany itself, which might be in a much better fiscal position, but it is a question whether its ailing economy can lift the weight of the Eurozone coming under renewed pressure.

In the US, the present government didn’t seek to correct the fiscal excesses of the previous one, but rather doubled down on them. The next government, whoever wins, is projected match the fiscal profligacy of its predecessors.

As a result, the world’s strongest economy is projected to pay at least 4% of its GDP in interest payments for the next few years, when that GDP isn’t forecasted to grow beyond 2.5%. The UK is in a similar position, paying 3/5% to 4.5% of GDP in interest payments, and growing by an average of just 1.3% in the next two years. So governments will have to pay for loans more than they grow each year.

Bond investors understand how unsustainable that is, and traders stand ready to “punish” those who will ignore their concerns. Hence the name “Bond Vigilantes”. For years they have been kept at bay by dovish central banks. The reappearance of inflation has made central banks more apprehensive about printing money at the pace of the previous decade. Combined with climbing debt, their presence means higher risks for debt markets.

Since the Chinese invented paper money in the 7th century, the boom-bust cycle of debt has repeated itself, always and without fail. Each time, there’s a legitimate excuse why “this time is different”, only to end up in a bust and the adoption of a harder measure of money, usually Gold, along with the pinky promise “not to do it again”.

The limitations of the global reserves of gold worth less than $22tn (including proven reserves) to support a global economy of $100tn, don’t preclude a reckoning at some point, a debt endgame. And the telltale sign of that endgame approaching is the faster accumulation of debt. As countries struggle with ailing demographics (higher average costs especially around healthcare), lower productivity, geoeconomic disruptions, old infrastructure and the Green transition, the only way to maintain their level of comfort is to borrow.

Presently, all major economies play a game of Russian roulette. They fire, pushing their debt limits even further, and hope that the chamber (a market event) is empty. Maybe it will hit the next government, and maybe it will be systemic, so they will be blameless. To be fair, this is not an even chance game. The US can bank on the strength of its global reserve currency status. France and the UK on their G7 status and the strength of their central banks. China on its massive reserves and the size of its economy. The sense of urgency is low, as equity markets, propelled by the AI and pharma trades, are at an all-time high. Bond market jitters tend to cause less political consternation, and downside, than stock market panics, unless spreads shoot up violently.

What does it all mean?

For governments, especially new ones like the UK labour government it means that unfettered fiscal expansion is a dangerous game. Shifting the accounting rules is a very old practice and might be less effective at a time when bond markets are looking carefully. Peeking through the bullet chamber to see if it is empty, which is what Ms Reeves is doing, is by no means an insurance, but at least a modicum of precaution. Ultimately, however, governments will need to figure out ways to significantly improve productivity if they are to maintain their citizens’ way of life.

For businesses, it means that the era of macroeconomic volatility will likely persist. Larger businesses, with good corporate treasuries, need to make sure they remain diversified in terms of currency and assets. They also will need to consider how much they are willing to pay to smooth cash flows, given that interest rates aren’t going back to zero anytime soon. Smaller businesses may have to be careful with debt accumulation. Unlike governments, they can’t print money to pay it off. Insolvencies in Germany and the US are already on the rise.

For consumers it means that financial planning will be more difficult. Markets will balance between higher inflation (due to debt) or deflation (if Chinese growth stalls), between higher rates (again due to debt and inflation) and much lower, at the cost of an economic crisis. Big investments (home, university) might have to be thoroughly planned years before execution.

Maintaining the primacy of Parliament, any Parliament, is very important and not just a matter of decorum. But as all governments are finding out, keeping an eye for bond vigilantes is simply necessary for their survival. Britain will serve as another litmus test, as to how much debt bond markets are willing to accept.

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Coming up this week

Investors need to keep an eye on two things this week: US payrolls and core personal consumption expenditure, the Fed’s favourite gauge of inflation. Strong employment and persistent inflation could push rate cut expectations even further and exacerbate bond market volatility. Conversely, weak employment and lower inflation could boost hopes for rates to come down sooner and provide a reason for a bond market rebound. Major market action will be deferred, somewhat, ahead of the US election on the 5th of November.

British investors will be additionally laser-focused on the budget. As we explain in this note, a non-market event is what Rachel Reeves is hoping for, and quite possibly (albeit never assuredly) what she will get, as she has communicated her intentions well in advance. ?A spike in UK yields, despite the early information campaign, could mean that markets are becoming wary of Britain’s fiscal position.