Has the stock market turned against Rachel Reeves?

Less than three months after delivering her first budget, Rachel Reeves finds herself in treacherous fiscal waters as rising borrowing costs in the UK erode her room to manoeuvre.

There is now a real risk that the chancellor will be forced to impose tighter fiscal policy from March, when the Office for Budget Responsibility presents its forecasts, as she seeks to meet her self-imposed budget constraints.

The situation is harmful for the Labor government in view of the claims of Reeves that his October tax declaration marked a landmark effort to “wipe the slate clean” when it comes to the UK’s budget woes.

How has the UK been blown off course?

The central problem is a stop turn up in government borrowing costs, in the UK and​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​​in the world. The United States has been a central factor in the sell-off of global bonds in recent months, driven in part by anticipation that tariffs imposed by US President-elect Donald Trump will fuel inflation.

But the United Kingdom was particularly hit by the anxiety of fund managers that the economy it could be entering a period of “stagflation”, where persistent price pressures prevent the Bank of England from cutting interest rates to push.

Combined with an increase in debt sales expected after the Budget, fears of stagflation helped send UK 10-year borrowing costs to their highest level since the 2008 global financial crisis and its 30-year borrowing costs at its highest this century. It also triggered bouts of weakness for the pound.

“The mix of pressure on gilts and the currency suggests that the market is worried about a UK recession or a fiscal event,” said Jim McCormick, a macro strategist at investment bank Citi.

Why is this so harmful?

The higher cost of borrowing has direct consequences for Reeves’ budget plans, increasing interest payments that already exceed £100 billion a year.

It has set a target to balance the current budget, excluding investment expenditure, by 2029-30. Forecasts in October from the Office for Budget Responsibility, the fiscal watchdog, suggest Reeves meet the rule with £9.9bn of margin to spare that year.

But higher interest costs put their goal in jeopardy. Yields on longer-dated gilts have risen steadily in recent weeks, with the 10-year gilt yield rising to 4.82 percent on Wednesday, the highest since 2008.

Ruth Gregory, economist at consultancy Capital Economics, said the moves seen so far would be enough to remove more of the headroom against the current budget rule, with the Treasury now on track to break the rule by nearly £1 billion.

This estimate is derived from market-implied expectations for the BoE’s benchmark interest rate and the 20-year gilt yield.

“No one should be in any doubt that meeting the fiscal rules is not negotiable and the government will have an iron grip on the public finances,” the Treasury said on Wednesday. “Only the OBR’s forecast can accurately predict how much the government has – anything else is pure speculation.”

Are there other factors affecting public finances?

The OBR’s forecasts for March 26 will also set out a revised view of growth, which will also have a significant impact on public finances. The GDP reading at the end of last year was weaker than expected and the BoE estimates that the economy did not grow in the last three months of 2024.

The poor data made the OBR’s October forecast for economic growth of 2 per cent in 2025 look vulnerable, analysts said.

But the effect of GDP movements on the loan depends on whether the OBR judges that the economy can recover and compensate for the shortfall later in parliament, or if it decides that there has been a permanent loss of production.

A downgrade by the OBR to its view of UK productivity and potential growth represents a further blow to the Treasury and public finances.

What can Reeves do?

The deterioration in the UK’s fiscal outlook comes as the government prepares for the next stage of its multi-year spending review, the results of which are expected in June.

The Treasury set its overall Whitehall departmental spending target in the October Budget, with daily spending to rise by 3.1 per cent in 2025-26 before falling sharply to 1.3 per cent growth in real terms by 2026-27.

Detailed plans for the initial year have been established; the expense review is now looked at in subsequent years. The officers have reported that if Reeves needed to make a correction to fiscal policy this spring, it would likely come via tighter spending plans rather than anticipated tax increases.

This is because he promised to hold only one “physical event” every year, which would be the time to change the taxes and it will not happen until the fall.

Restoring the height to its October levels of just under £10 billion via tighter spending plans would mean slowing real terms growth in daily departmental spending from 1.3 per cent a year to just under 1 percent, said Ben Zaranko, associate. director of the think-tank of the Institute of Fiscal Studies.

But analysts fear that if the sell-off in the bond market persists, Reeves could be forced to go further in an attempt to support fiscal credibility. Such action could involve tax increases and limitation of front-loaded expenses, and not just votes of more discipline later in the parliament.

“Reeves could soon face a tough choice of breaking his fiscal rules or announcing more tax increases and/or spending restrictions at a time when the economy is already weak,” Gregory told Capital Economics.

What other options are there?

The chancellor aims to focus on a “pro-growth” narrative in the coming weeks, and faster economic expansion would pay dividends in terms of public finances.

Reeves is preparing for a trip to China this week as he looks for ways to stimulate the economy.

But hopes for a sharp turnaround in GDP growth could easily be misplaced. With the intensification of declines in the prices of government bonds, investors have warned that attempts to establish a strong fiscal base for the current parliament are in danger.

Reeves “has run out of room as selling has been relentless since October,” said Pooja Kumra, UK rates strategist at TD Securities.

Data visualization by Keith Fray