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Gilt investors have told the UK Labor government it may have to raise taxes further if it wants to maintain credibility in the bond market after its borrowing costs rose to their highest level since the financial crisis.
Chancellor Rachel Reeves has vowed not to repeat October’s £40bn Budget tax hike, which many businesses say has acted as a drag on economic activity. But some bond market participants warned that the UK government may have to look to taxes to shore up its finances after losing its room to maneuver under self-imposed fiscal rules.
Mahmood Pradhan, head of global macro at the Amundi Investment Institute, said the UK government “should not be boxed in by ruling out a tax hike” and that “promises of spending restraint alone may not be enough to convince markets “.
A punishing few months in global bond markets, partly fueled by the prospect of US President-elect Donald Trump’s inflationary policies, have pushed 10-year UK bond yields to a record high of 16 -year-old and have erased the government’s space against its fiscal rules. .
On Tuesday, Reeves told parliament she was “absolutely committed” to sticking to her fiscal rules, as she deflected questions from MPs about whether she would be forced to cut public spending.
New tax increases would be politically toxic and further undermine Reeves’ political standing.
UK 10-year bond yields rose from 3.75 percent in mid-September to a 16-year high of 4.93 percent last week, as a global bond selloff mixed with investor concern that The UK economy is entering a period of stagflation – where persistent price pressures constrain the Bank of England from cutting rates to support an economy in decline.
On Wednesday, 10-year bond yields rose to 4.82 percent in morning trading as inflation data opened the door for faster BoE rate cuts. Yields move inversely to prices.
Ranjiv Mann, senior portfolio manager at Allianz Global Investors, said any further rise in yields would “increase pressure on the government to take steps to address the budget shortfall in March rather than waiting for the budget in the autumn “.
The government could take “corrective action”, Mann said, such as a real-terms spending squeeze in so-called vulnerable departments such as local government, or extending a freeze on personal income tax thresholds beyond 2028.
Robert Tipp, head of global bonds at asset manager PGIM, said he thought the UK government could be forced by market moves to “give way” in its tax position, rather than relying on spending restrictions . “It’s a classic example where hope would be a bad strategy,” he added.
Peder Beck-Friis, economist at bond giant Pimco, said it was becoming increasingly likely that the UK government would have to address its deteriorating fiscal position.
“We would be very surprised if the government did not adjust taxes or spending to meet these fiscal rules. . . we expect the government to maintain fiscal credibility and regulate these variables.”
There is now a risk, investors have warned, that if the government does not come forward with further fiscal tightening, the gaps are sold further as investors build more of a “fiscal risk premium” into the debt.
Reeves stressed on Tuesday that global factors had boosted bond markets around the world and reiterated her pledge to keep just one budget a year.
The Government Office for Budget Responsibility will provide updated economic and fiscal forecasts on March 26.
The recent gains in bond yields, if sustained, would be enough to wipe out more than £9.9bn of fiscal space Reeves left herself in her October budget. Some economists also expect the OBR to lower its growth forecast for 2025 from the current forecast of 2 per cent released in October.
A reduction in long-term growth forecasts would further hit the chancellor’s budget space, adding to her fiscal challenges.
Robert Dishner, senior portfolio manager at Neuberger Berman, said the government could consider changing policies such as increasing employers’ national insurance costs to reduce its inflationary effect and even consider commissioning a review externalities of the efficiency of government spending.
“Are there excessive costs? The government can probably find some savings here or there.”
A Treasury spokesman said: “This government’s commitment to fiscal rules and sound public finances is non-negotiable. The chancellor has already indicated that tough decisions will be taken on spending, with the review of spending to eradicate waste going on.”
Additional reporting by George Parker