It is with no pleasure that I must report a depressing domestic byproduct of the war in the Middle East: headroom chat is back.<\/p>\n
Of course, shifts in investors\u2019 appetite for gilts \u2013 UK government bonds \u2013 are trivial in the context of the bloodshed in Iran and beyond. But as a result of the economic chaos unleashed, gilt yields, which determine the interest rate on government borrowing, have resumed their grip on British politics. And one of Rachel Reeves\u2019s proudest boasts, the \u00a323bn in \u201cheadroom\u201d she had built up against her fiscal rules, is in jeopardy.<\/p>\n
Less than a month ago, the chancellor was able to stand up in the House of Commons and report that her headroom had increased<\/a> since November\u2019s tax-raising budget<\/a>. Her (not unreasonable) hope was that this generous cushion would free her from minute scrutiny by bond investors, allowing her to spend the year focusing on conquering inflation and kickstarting growth. With both of those ideas now looking fanciful, however, Reeves\u2019s financial breathing space is at risk once again.<\/p>\n Four weeks into the devastating conflict in the Middle East, the yield \u2013 in effect the interest rate \u2013 on 10-year gilts has surged to its highest levels<\/a> since the global financial crisis of 2008, ending last week a whisker off 5%. That will push up the government\u2019s cost of borrowing, and by extension the cost of just about everything it wants to do.<\/p>\n With oil prices up about 50% since the onset of the war, and the impact rippling out into other commodities, the jump in yields reflects higher expectations for inflation and interest rates. Investors who had been betting on further rate cuts in the UK have dramatically reversed course and now expect rates to rise twice or more this year as the Bank of England reacts to surging prices.<\/p>\n As several members of the Bank\u2019s monetary policy committee seemed at pains to hint last week, the markets may have got ahead of themselves. Rate setters have to balance the risks of rising inflation against the weakness of the economy. But weaker growth, caused by the cost shock barrelling towards the UK economy, will also hit the Office for Budget Responsibility\u2019s forecasts for tax and spend, which are highly sensitive to small changes in the outlook.<\/p>\n As Thomas Pugh, of the consultancy RSM, put it in a note last week: \u201cThe combination of higher inflation, weaker employment and surging gilt yields means the chancellor has probably already lost a third, or even half, of her headroom.\u201d<\/p>\n The UK has not been the only country that has seen wild moves in the price of its bonds since the onset of war: Germany\u2019s 10-year yield, or interest rate, which moves in the opposite direction from the price, is also up sharply, by almost half a percentage point, for example. Even with US Treasury bonds, usually seen as the ultimate safe haven, yields have risen, raising wider questions about the stability of the global financial system.<\/p>\n Yet the shift up in interest rates in the UK has been larger, at close to 0.7 percentage points. And the fact the government\u2019s debt management office needs to sell \u00a3250bn worth of bonds this year \u2013 to borrow that much from investors, in other words \u2013 means no politician will have the luxury of ignoring the market.<\/p>\n So Reeves faces a repeat of last year\u2019s corrosive speculation about what action she may decide to take in the autumn to keep her forecasts on track. And if a Labour<\/a> leadership contest is triggered after the May local elections, candidates\u2019 every pronouncement on tax and spend will be scored instantly by febrile markets.<\/p>\n The US hedge funds that are often the marginal buyers of gilts tend not to be experts in the minutiae of internal Labour party politics, but they don\u2019t generally like uncertainty, or \u2013 as the Liz Truss farrago underlined \u2013 plans for massive unfunded splurges.<\/p>\n That doesn\u2019t mean there is zero room for manoeuvre, but it does mean any shift in tax and spend would have to be carefully plotted out and explained, to avoid being swamped by surging interest rates set by global investors.<\/p>\n Perhaps it\u2019s not surprising, then, that Angela Rayner has apparently been mooting the resolutely sensible John Healey<\/a> as a potential chancellor \u2013 though the less radical any reset on economic policy, the less appealing the pitch may be to Labour MPs hungry for change.<\/p>\n