If you’re a politician, the bond market can be a harsh taskmaster. Bill Clinton’s Chief Strategist, James Carville, famously said: “If there was reincarnation, I would want to come back as the bond market. You can intimidate everybody.” Liz Truss was forced out of office after just 44 days following a bond market rout. Now, Manchester Mayor, Andy Burnham (currently 6/1 at the bookmakers for being the next PM), has said: “We’ve got to get beyond this thing of being in hock to the bond markets.”

Much of the tension between politicians and the bond market comes from an often-wilful misunderstanding of what the bond market is and what drives investor returns (yields). So, let’s do some myth-busting on the bond market and understand how we could get out from under its thumb.

What is a gilt?

When we need to borrow money, you and I will probably get a personal loan or maybe a credit card. When the British government needs to borrow money, it issues IOUs. These IOUs are government bonds and the name for the British-flavoured ones is ‘gilts’.

The stock of gilts – the cumulative amount of these IOUs – has now risen to about £2.9tn or 96% of GDP.

Who do we owe the money to?

About one third of that £2.9tn is owed to overseas investors. Another fifth or so is owed to UK insurance and pension funds. If you have a pension, then you probably own some gilts. Just under a quarter is owned directly by households and banks. The final quarter or so is owned by the Bank of England (BoE). This is a bit odd because the BoE is part of the government, meaning it essentially owes the debt to itself. But, the BoE is reducing its share by gradually running down its stock of bonds. It's doing this by letting gilts mature and not reinvesting the proceeds, or by actively selling on secondary markets the gilts it still holds. This is quantitative tightening. (The opposite of quantitative easing.) In any case, two-thirds of UK government debt is ultimately owed to other parts of the UK (see chart on gilt holdings).

There is, of course, a cost to this borrowing. Last year the government spent about £105bn on debt interest. That was about 8% of total government spending and the third biggest budget line item after welfare and the NHS.

What determines the cost of borrowing?

There are broadly three factors that determine the cost of borrowing.

The first is credit risk. Basically, this is how likely are you to get paid back. If you’re lending to a corporate or household, then there’s a chance of bankruptcy and losing all your money. The UK government is different because if all else fails it can simply just print enough money to repay its debts. This means there’s virtually no chance of actually losing money if you’re a lender. Of course, printing money can lead to higher inflation, meaning your initial loan is worth less in real terms.

That leads me to the second point. Inflation risk. This is the big one. It’s the primary reason why the cost of borrowing has risen over the last few years. Since the financial crisis, inflation has been low (around 2%) and stable. That meant the base rate – the interest rate set by the Bank of England – was also low and predictable. Investors were happy getting a relatively low return. Now that inflation is much higher and more volatile, and the base rate is higher, investors also need a higher return to justify lending the government money. Lending money at 4% starts to look like a poor deal if inflation is also 4%.

It's much easier to forecast these variables over the short term (1–2 years) than the longer-term (10 or more years). That’s why it’s almost always more expensive to borrow for longer. Who would’ve forecast 10 years ago that we would’ve had a pandemic and an energy crisis? More uncertainty requires more compensation.

Finally, good old supply and demand plays a role. Bigger budget deficits mean the need for more gilts, or IOUs. This lowers the price of gilts in the same way more supply of anything tends to push prices down. It also raises the cost of borrowing for the government. That's because bond prices and yields (returns) move in opposite directions. A lower bond price means a higher cost of borrowing.

Government policies that would significantly push up inflation and borrowing (cough, Liz Truss mini budget, cough) therefore push up gilt yields.

There are two reasons the UK is especially impacted here. The first is because we’re running a large budget deficit (increasing gilt supply) at the same time as the BoE is selling bonds (also increasing gilt supply). Second, previous big buyers of government bonds, such as defined benefit pension schemes, have exited the market (decreasing gilt demand). Put all these things together and it’s not difficult to see why borrowing costs have risen, especially for longer dated bonds, even though the BoE base rate has fallen. Inflation is higher and more volatile. The geopolitical outlook is more uncertain (will the Federal Reserve still be independent in 10 years?) and governments around the world, from Germany to the US, have big borrowing plans, increasing the supply of government debt.

What can we do about it?

If you want to be less, as Andy Burnham says, “in hock” to the bond market, then the obvious answer is to borrow less. This could mean spending less. But, given the government couldn’t even get cuts worth a mere 0.4% of spending through parliament, spending cuts look off the table. That leaves tax rises. The problem is that the UK’s tax take is already at its highest level since the second world war and the government has ruled out increasing the biggest revenue-raisers of Income Tax, National Insurance Contributions (NICs) and VAT.

There are, however, a couple of possible ways out of this unfortunate situation. The best route would be to raise the economy’s growth rate through supply-side reforms. Think of things like serious re-organisation of the planning system, addressing bad taxes (cliff edges, stamp duty etc), making it easier to switch jobs and changes to immigration policy. While they may need some political capital investment, these wouldn’t cost the government any money. They would also boost growth over the medium to long term, therefore raising more revenue.

If supply-side reform is too difficult, then the government should at least look to raise money in a bond-market friendly way. That would mean focusing on taxes that dampen inflation and the future path of interest rates, rather than raising inflation, and have the least distortionary impact on the economy. Property and income taxes for example tend to be deflationary and less-distorting. Employer taxes and duties tend to be stagflationary and can have large unintended consequences, which we’ve seen with the impacts of employer NICs on the labour market and inflation.

Getting out from under the bond market's thumb is relatively straightforward for an economist. It looks much harder for a politician.

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