Labour infighting puts chancellor’s budget plan to reassure bond markets at risk

There is one narrow, perilous route by which Rachel Reeves can successfully deliver her 26 November budget, and it runs right through government bond markets. But the current outbreak of Labour infighting – driven by a flurry of pugilistic briefings from inside No 10 – risks cutting that route off with two weeks still to go before budget day. Before news broke of an abortive leadership challenge, the chancellor had been carefully laying the groundwork for a tough statement, likely to include busting Labour’s manifesto pledges by raising income tax. One rationale for that drastic, manifesto-breaking step is the Treasury’s belief that if Reeves acts decisively to build up more “headroom” against her fiscal rules, investors will be reassured about her determination to fix the public finances. The chancellor’s hope is that will help to eliminate what has become known as the “moron risk premium” for the UK government’s bonds, known as gilts – making it cheaper for the Treasury to borrow. The term was coined by Dario Perkins, of research firm TS Lombard, in the brief but chaotic Liz Truss period three years ago. Back then, investors were effectively demanding a small additional premium to hold UK government debt, to allow for political instability. That moron premium has never completely disappeared, despite Starmer and Reeves pitching themselves as the guarantors of fiscal stability. As Reeves told the Guardian last month: “When Liz Truss and Kwasi Kwarteng did their mini-budget three years ago, our bond yields decoupled from other G7 economies and they are still at an elevated level compared with other countries. I want to bring us back in line.” The market clearly likes the messaging around tax hikes and headroom: the 10-year gilt yield had drifted down from above 4.7% in early October, before Reeves began talking frankly in public about tax rises, to less than 4.4% before the latest wave of speculation about Keir Starmer’s future. Lower bond yields – which move in the opposite direction to prices – would help to bring down borrowing costs across the economy. Reeves has also made clear she intends to take direct action in the budget to bring inflation down. Add more quiescent bond markets to weaker inflation, and it is just possible to imagine a future in which the government’s monster interest bill of more than £100bn a year eases. In that rosy scenario the Bank of England cuts rates a couple more times, cost of living pressures for households abate, and business and consumer confidence rebounds into 2026. But that narrow path depends on retaining a measure of credibility with the markets – hence a series of carefully choreographed meetings the chancellor and her colleagues have held with City investors in recent weeks, as they prepare the ground for 26 November. Even if the package of measures is the right one, there were already questions about whether it could be successfully implemented – fuelled by the backbench rebellion over the botched welfare cuts in the spring statement, and the ditching of the politically toxic winter fuel payment cut. Then there’s the practicality of trying to govern and maintain party discipline when you have just torn up a key manifesto pledge. But after Wednesday’s political briefing wars, any potential benefit the Treasury may have hoped for in terms of market confidence has been put at risk. Neil Shearing, chief economist at the consultancy Capital Economics, says the budget will be watched intently by bond investors, with markets expecting perhaps £30-35bn of tax rises and spending cuts. But given the political backdrop, their attention will now rapidly shift to Labour’s backbenches. “It all becomes: ‘How has this landed with the PLP [parliamentary Labour party], is her job safe, is the PM’s job safe?’” Any sign that Reeves and Starmer are at risk is likely to spook investors – an argument that No 10 have apparently been brandishing against would-be plotters. Markets did react negatively on Wednesday to the briefings overnight, with the yield on 10-year gilts up – only by one basis point, but moving in the opposite direction to US Treasury yields, which the UK otherwise tends to track. “Today’s price action is telling. It’s moved off budget to political risk,” said Sanjay Raja, of Deutsche Bank. “The market focus is moving away from the budget and potentially to the price the chancellor and the PM have to pay for this budget, which ultimately could come out in a leadership challenge.” This renewed emphasis on political instability will be particularly galling in the Treasury, after Reeves’s pitch-rolling for manifesto-busting tax increases appeared to have been successful in calming markets in recent weeks. As Shearing says: “It was all moving in the right direction: this has put that at risk. The government has shot itself in the foot.”