The UK gilt market suffered a sharp shock on Friday after Chancellor Rachel Reeves abandoned plans to raise income tax in the upcoming November 26 Budget.
The dramatic U-turn sparked a bond market rout, with 10-year gilt yields jumping 14 basis points and 30-year yields soaring as much as 14 basis points in early trading.
The move leaves Reeves scrambling to plug an estimated £30-35 billion fiscal gap with alternative tax measures instead.
Investors are now worried about unfunded spending pledges and broader economic implications, signaling deep uncertainty about the government’s fiscal roadmap just two weeks before the critical budget announcement.
The bond market revolt: Fiscal credibility under fire
The gilt market’s reaction was unmistakable: investors punished Reeves for backing away from the most straightforward tax lever available.
By early Friday, the 10-year gilt yield settled around 4.5% after the initial spike, while 30-year yields remained elevated at 5.3%, up seven basis points on the day.
The problem is clear: the bond market abhors uncertainty, especially when it comes to unfunded spending. Reeves had previously hinted at a broad-based income tax hike as the cleanest way to raise revenue.
By scrapping it, she’s forced to pursue what economists call “death by a thousand cuts,” a messy patchwork of smaller, economy-damaging tax increases scattered across relief programmes, levies, and business taxes.
The timing couldn’t be worse. With the UK economy already sluggish, GDP growth was just 0.1% in Q3, and the bond market is signaling that any anti-growth tax measures will only worsen the outlook.
Thomas Pugh, chief economist at RSM, noted that dodging income tax hikes “raises the chances that the Chancellor has to resort to tax changes that are either inflationary, have severe distortionary effects, or worse, both”.
Add rising gilt yields into the mix, and government borrowing costs are climbing precisely when the Treasury needs to refinance debt.
The spiral is real: higher yields mean bigger interest payments, which means less fiscal room to maneuver.
The chancellor’s dilemma is brutal. Political pressure forced her away from the income tax hike, but the bond market is now demanding she explain how she’ll close the black hole without derailing growth.
Either she broadens the tax base with measures that hit middle-income earners or smaller businesses, or she cuts spending; neither option is politically palatable.
The Pound’s pounding: Currency weakness signals alarm
Sterling became the worst-performing G-10 currency on Friday, sinking to fresh two-year lows against the euro and falling roughly 0.5% against the dollar.
GBP/USD dropped to around 1.3100, reflecting not just the fiscal mess but also shifting expectations for Bank of England interest rate cuts.
As gilt yields rose, traders trimmed their bets for a December BoE rate cut, with probability falling from near-certainty just weeks ago to around 75%.
The pound’s weakness underscores a deeper concern: investors are losing faith in the government’s ability to manage the fiscal challenge.
Political turmoil surrounding Prime Minister Keir Starmer earlier this week didn’t help; it signaled chaos in the corridors of power at precisely the moment calm and clarity were needed.
For sterling, the combination of fiscal uncertainty and dovish BoE expectations proved a one-two knockout punch.
Higher UK yields typically support the pound by attracting foreign capital, but when those yields are driven by fiscal concerns rather than growth, investors flee instead.
Analysts are now questioning whether Reeves will reverse the reversal. In the past, she’s shifted course based on bond market pressure.
If gilt volatility continues to spike heading into November 26, expect another dramatic policy shift.
The alternative: sticking with the income tax U-turn and rolling out dozens of smaller tax measures, risks a “bloodbath” for gilts and further weakness in sterling.
For the Bank of England and UK borrowers, higher yields could mean delayed rate cuts and tighter financial conditions just when the economy needs stimulus.
The Chancellor has just two weeks to regain market confidence, and time is running out.
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