Britain is on course for a nasty economic shock

The bond market was highly reactive to Rachel Reeves’s tears – and Sir Keir Starmer’s initial failure to back her - Jack Hill /PA Media

Rachel Reeves’s tearful appearance in the House of Commons this week was a shock to the system.

Her distress was a rare human moment in the vicious game of politics that highlighted just how stressful it is carrying the weight of the country’s economy on your back.

Yet the bond market reaction to her tears – and the Prime Minister’s initial failure to back her – were a reminder of something else: that the UK’s public finances are in an extremely precarious position.

With such a small buffer to balance the books, the Chancellor’s every word – and even sniffle – has come to matter. Speculation is already mounting about the size and scale of tax rises needed this autumn to maintain her £9.9bn headroom, with numbers in the £30bns floated.

Reeves's headroom was already wafer-thin

Unfortunately for both Reeves and Britain, this may be the best-case scenario.

A series of potential shocks are lurking around the corner that could mean the true scale of the financial hole facing the Chancellor by the autumn is even worse.

Donald Trump’s “big beautiful bill” of sweeping tax cuts is already threatening to push up global borrowing costs, with the package set to increase US borrowing by $3.3 trillion (£2.4 trillion) at a time when debt is already soaring.

Back in 2017, Trump reduced taxes for households and businesses in a move that was scheduled to expire at the end of this year. Trump’s new bill will make them permanent and introduce an array of new write-offs, including tax-free tips and overtime.

Bond investors seem to be cautiously accepting the bill, waiting to see if Trump’s prediction that the tax cuts will pay for themselves through higher growth. But if that proves not to be the case, the bond vigilantes may soon sweep in an force a change.

The International Monetary Fund (IMF) sees more than a one in three chance of a US recession, which would have major implications for global growth.

The US president’s trade war will also come back into focus next week when the reciprocal tariffs set out on “liberation day” come into effect after the 90-day “pause” comes to an end on July 9.

The initial announcement of those tariffs triggered violent moves in the bond market in April. Could that be repeated again next week?

Mohamed El-Erian, the chief economic adviser at Allianz, says it is likely that any nervousness among investors about higher tariffs will inevitably spill over into the UK. After all, history shows there is a strong correlation between US and UK borrowing costs, with interest rates also moving pretty much in lockstep.

“The UK is sensitive to what happens in the US simply because it cannot avoid spillovers from the world’s biggest economy,” he says.

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“Having said that, the real concern is when you have UK specific issues compounding the spillovers. That’s when things get bad.”

Life after Reeves

That is precisely what is happening at the moment. A series of about-turns on key policies have sent Reeves’s financial plans into tailspin and shaken faith in Labour’s competency.

“The changes we have seen ever since the first announcements from the Labour Party – and the intended changes they wanted to put forward – have subsequently been either watered down or changed. That’s what the bond market does not like,” says Sonja Laud at L&G investment management.

“[Markets] can’t trust that what’s been put forward will be put in place.”

Simon French, the chief economist at Panmure Liberum, says constant flip-flopping on policy is starting to “look like ineptitude”.

He adds: “The issue for the Prime Minister is that this ineptitude is rather deeper than scapegoating one person – even his Chancellor. This looks like a systemic problem within his own party.”

Some in the City are already speculating about life after Reeves.

“Perhaps the markets were even thinking forward to the possibility of Angela Rayner as PM,” says one financier. “They would view the current Deputy PM as absolutely increasing the fiscal risks.”

For now, the market reaction has been relatively muted. But El-Erian warns that bad news can quickly compound to trigger pyrotechnics in the bond market.

“That happened during the Liz Truss period when bond markets were already destabilised by what was happening in the US and then you got a UK-specific shock that amplified to a tremendous amount the move in yields,” he says.

“If you ask me what’s the greatest vulnerability, it’s when both of these things happen at the same time.”

As the Office for Budget Responsibility (OBR) has highlighted, it wouldn’t take much to knock Reeves off course. Had the rise in gilt yields on Wednesday been sustained, it would have reduced the Chancellor’s £9.9bn buffer by £3bn.

That’s before taking into account the cost of all of the welfare and winter fuel payments climbdowns.

As it stands, much of the surge in gilt yields went into reverse after Sir Keir Starmer finally offered a full-throated endorsement of his Chancellor, saccharine as the love-in was.

Testing investors’ patience

Yet borrowing costs are not back to where they were before Sir Keir gutted his benefit reforms to head off a rebellion.

“Wednesday’s moves serve as a reminder of how parlous the UK fiscal situation is, and that it is testing investors’ patience,” says Diana Iovanel, at Capital Economics.

“There is very little fiscal headroom, and all of the options available to Reeves are unappealing.”

Shock waves from Trump’s big beautiful bill are just one risk facing Britain. As the war in Ukraine has demonstrated, the UK is also vulnerable to global energy prices, and the recent US attack on Iran was a reminder that geopolitical tensions can quickly escalate.

One of the clearest ways such events affect the British economy is through inflation. In an unstable world, things tend to cost more.

The danger is that an inflation shock forces the Bank of England to keep interest rates higher for longer, further eroding Reeves’s headroom and forcing her to find savings or raise taxes even further.

0407 Tax burden on workers to jump

The OBR notes that it would only take a 0.6 percentage point rise in Bank interest rates to wipe out Reeves’s headroom altogether.

Peder Beck-Friis, an economist at Pimco, suggests Reeves should focus on keeping inflation low so that the Bank of England can cut interest rates faster. This could create a virtuous circle of helping to support growth and lower borrowing costs, a move that would simultaneously put more money into people’s pockets and the Chancellor’s coffers.

“The labour market is weakening, inflationary pressures appear to be easing, and more tax hikes in the autumn will likely add pressure on the Bank to be the shock absorber,” he says.

Meanwhile, there is already pressure on the Bank to revamp its emergency bond buying scheme, which is passing on heavy losses to the taxpayer now that it is selling rather than buying them. Critics want the central bank to stop offloading bonds to ease pressure on public finances.

Catherine Mann, a member of the Bank’s Monetary Policy Committee (MPC) that sets interest rates, has said policymakers must pay closer attention to the impact of quantitative tightening (QT) on financial markets and the wider economy. She estimated that QT could raise borrowing costs by almost a quarter of a percentage point.

Ultimately, however, the main thing Labour needs to do to help guard against an unexpected shock is to grasp the nettle of public spending.

A toxic combination of high and rising debt, higher interest rates and the difficulty of imposing spending cuts have led investors to question whether governments all around the world will be able to meet future debt repayments.

Labour’s failure to push through spending cuts means tax rises are almost certain in the autumn. But there is only so much that the economy can bear before it begins to hit growth.

There is only so much that markets can bear, too.

“There are no hard and fast rules when the market will say enough is enough, but you’ve seen the reaction in the gilt market yesterday that there clearly is an unwillingness to accept that lack of clarity,” Laud says.

Her remarks suggest that for all Sir Keir’s talk of the damage done by Truss, growing signs of fiscal fatigue may make traders turn on him too.

And when markets turn, they turn quickly. With so much global uncertainty, the fates of Reeves and Sir Keir may already be out of their hands.

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