Rachel Reeves’s test from the bond markets starts now

Good news for Rachel Reeves: the cost of government borrowing has fallen a bit relative to the US and eurozone countries. Better news: the chancellor may have something to do with it. Better still: some economists think there’s more to come.Let’s not get carried away, though. The UK is still paying a painful premium on its borrowing costs, as the Institute for Public Policy Research thinktank illustrates. Since last year’s general election the yield on 10-year government gilts is up almost 70 basis points – or seven-tenths of 1% – compared with US Treasury bonds, and the increase versus the eurozone is almost 25 basis points. The gaps are wider for 30-year bonds and the consequences are real. IPPR calculates that if the premium could be reduced to zero, the Treasury would save as much as £7bn a year until 2029-30.A key point here is that the premium can’t be wholly explained by factors that are widely acknowledged and beyond the government’s control: the reduced appetite for gilts among mature UK defined-benefit pension funds, for example, and the Bank of England’s steady selling of the gilts it bought in the years after the great financial crisis.The reality behind the yield premium is that the UK isn’t getting much credit for having debt and deficit ratios that, while definitely not pretty, are less horrible than those of many other G7 countries. The explanation will relate to some combination of the market’s doubts over long-term inflation and the government’s willingness to stick to its fiscal plans.So the improvement in sentiment – if that is what is – in the last few months is significant if it continues. IPPR suggests there was a turning point at the Labour conference in September, when Reeves said “there is nothing progressive, nothing Labour” in spending almost £1 in every £10 of public money on debt interest. She also made it clear that after U-turns on welfare spending she was in the business of rebuilding headroom against her fiscal rules.Bond yield graphic“The government’s strong recommitment to its fiscal plans does appear to be reducing costs more recently,” the IPPR report says, noting the fall of 20 basis points since the conference.It’s more of a struggle to detect a serious move since last month’s budget. IPPR sees “early/tentative signs” of further progress but 10-year gilt yields still stand almost exactly where they were on the day at 4.5%.On one hand, the market clearly likes the comfort blanket of £22bn of fiscal headroom and the (slightly) greater credibility on the ambition to halve the annual deficit over the life of the parliament. On the other, the back-loaded nature of Reeves’ tax rises creates worry about whether they will happen. Meanwhile, the Office for Budget Responsibility downgraded the outlook for growth, and the communications chaos in the run-up to the budget hardly boosted confidence.But there is a sketch of a possible positive narrative here for Reeves. Financial markets expect the Bank of England to cut interest rates three times by the end of next year as inflation in food prices and energy cools. One can already see banks scrapping a bit harder on mortgage rates. A further boost would come if gilts markets were less punishing of the UK and if the political risk premium were to reduce further. It would help, as IPPR suggests, if the Bank, as the biggest owner of gilts, was a less enthusiastic seller.skip past newsletter promotionafter newsletter promotionThe alternative script is the one outlined by Oxford Economics in its outlook for 2026: “We expect markets will increasingly question the fiscal credibility of the budget and the survival of the Labour leadership. A slow burn of a steepening yield curve and weaker sterling could morph into a more serious confidence crisis.” It points to “no sign of a sustainable growth driver”, which is also the view in much of the business world.Timing matters if, as the Westminster watchers say, next May’s local elections are the next critical political moment. If the UK’s yield premium continues to fall towards the level the government inherited, Reeves has the gist of an “it’s working, be patient” narrative. But it does need to happen.