Rachel Reeves will need to lay out harsh spending cuts to offset higher borrowing costs in her Spring Statement this month, investors have warned, as a recent rise in bond yields intensifies the pressure on the UK chancellor.
The Office for Budget Responsibility on Wednesday said its preliminary fiscal forecasts were based on the UK’s borrowing costs during the 10 working days to February 12, which excludes the more recent rise in gilt yields.
Analysts at Capital Economics said Reeves was on track to miss her key fiscal target by a margin of £1.6bn, in part because of higher borrowing costs during the OBR window.
If a more recent period was used to assess interest rates, however, the damage would be nearly £1bn greater, they said.
Investors said the figures underscored the need for Reeves to shore up the public finances on March 26 by more than the minimum required by the OBR’s forecast to reassure markets that she is keeping the deficit under control.
David Zahn, head of European fixed income at asset manager Franklin Templeton, said March 26 was shaping up to be a “huge day” for the gilts market. He said investors were expecting significant spending cuts.
“If they come with not much [in terms of cuts], gilts will be under pressure again,” said Zahn. “It is a very fine line that they are walking.”
Reeves has been under growing fiscal pressure since the Budget as bond yields have climbed, growth has stagnated and borrowing has overshot expectations.
Recently yields have started ticking up again, driven by investor expectations that Europe will have to borrow more to fund defence spending — a dynamic on dramatic display last week with German plans to fund hundreds of billions of euros of military and infrastructure spending with debt.
The 10-year gilt yield was back up to 4.7 per cent on Wednesday, from below 4.4 per cent at a recent intraday low in early February. Yields move inversely to prices.
“With the international position unlikely to get any easier, rebuilding the headroom they had in October feels like the bare minimum — ideally they should go beyond this,” said Ben Nabarro, UK economist at Citi.
He said this could entail building £15bn in headroom in the Spring Statement. “With worse news plausibly ahead, further tax increases are a matter of when, not if.”
Reeves had previously pitched her statement on March 26 as a routine briefing to the House of Commons following the OBR’s forecast. She has promised to only hold one “major fiscal event” a year, in the autumn, implying tax changes would come just once a year.
Now she is expected to unveil a further retrenchment in the public finances, with welfare and departmental spending set to take a hit. Senior government officials insisted that cuts to the welfare system — expected to save at least £5bn a year — would have been executed regardless of the state of the public finances.
“They would have happened whether the headroom was £2bn or £20bn,” said one official.
Reeves in October left herself £9.9bn of headroom against her key fiscal rule, which requires her to fund day-to-day spending entirely with tax receipts by 2029-30.
But increases in yields immediately after the October Budget pointed to investor jitters about the fine margin the chancellor had left herself — in the context of a government that spends £1.3tn a year.
Ten-year gilt yields touched a 16-year high in January at 4.93 per cent as UK economic concerns mixed with a global bond sell-off, intensifying concerns about the chancellor’s ability to hit her budget rules, before the debt rallied.
As Donald Trump has sown doubts in Europe about the US commitment to European security in recent weeks, borrowing costs have climbed again.
“With the movement that we have seen in yields more recently, [the] headroom is quickly diminishing,” said Craig Inches, head of rates and cash at Royal London Asset Management.
Goldman Sachs said in a note on Tuesday that it expected spending cuts worth about £10bn a year by the end of the forecast horizon as the chancellor bids to restore her fiscal headroom.
It thinks the new projections will most likely show the government “narrowly missing” its current deficit target, with projections for interest costs likely to “rise notably”.
The OBR said on Wednesday its fiscal forecast would also incorporate revisions to GDP data that were released at the end of September but which came too late to be factored into its October forecast.
These revisions would have raised the starting point for the size of the economy in its Budget forecast, but the OBR said in its October outlook that they would not have “materially” impacted its growth and inflation forecasts had they been able to account for them.
Analysts said Reeves could gain some flexibility thanks to Prime Minister Sir Keir Starmer’s decision to raid the UK’s foreign aid budget to fund his £6bn a year increase in defence spending by 2027.
Some of this spending will probably be treated as capital expenditure, which doesn’t count towards Reeves’ rule requiring her to record a current budget surplus in 2029-30.
“The Government’s commitment to fiscal rules and sound public finances is non-negotiable,” said a Treasury spokesperson. “We do not comment on speculation around OBR forecasts.”
Additional reporting by George Parker in London
