Bond hysteria, a leaky Hormuz and fiscal incontinence

Whilst equity markets have had a relatively uneventful week, bond markets have been bordering on hysterical, which is an unusual confluence. Geopolitics have also returned to the top of the “things to worry about” list, largely thanks to increased tension in the war between the US and Iran, further exchanges of fire (albeit limited), and an inevitable rise in oil prices. Controversially, I think higher energy prices are affecting bond markets right now, not the scale of government borrowing, which most commentators seem obsessed with. (The so-called bond market vigilantes schooling the new PM and his Chancellor is the most popular but wrong story.)

Finally, I couldn’t resist the temptation to have a go at some of Mr Burnham’s comments in his first PMQs this week, which were so ridiculous they made me laugh out loud.

The Gulf, again

So, first, the war in the Gulf and the first exchange of fire between the US and Iran for about a month. Inevitably, rising tension and concerns that the conflict might once again escalate materially have immediately affected oil prices and appear to have also influenced gas prices in Europe (see chart below).

With Brent crude at $96 and European gas prices at €72.3, one might be tempted to believe, as many were earlier this year, that we are about to embark on another existential energy price-induced inflation spike. I am not so sure. In the first place, Brent peaked at $120 earlier in the year and, despite remaining elevated throughout the spring and summer, UK inflation fell.

Whilst it is fair to accept that UK inflation will likely pick up a bit from its current 2.9% level, talk of 4–5% by the year-end just looks ridiculous to me.

Finally, it is also worth bearing in mind that more reports are coming out of the Gulf this week indicating that the Strait of Hormuz is somewhat more permeable than many commentators might have believed. For example, CNN reports that the US military escorted 40 vessels carrying 18mn barrels of oil through the Strait of Hormuz on Tuesday. (The pre-war daily average was about 20mn barrels of oil and petroleum products.) The US Energy Secretary has again said that oil is flowing out of the Gulf, and that on Monday 17mn barrels exited the waterway; traders’ estimates put the average at 6–8mn barrels a day in recent weeks.

Also in relation to the impact higher energy prices might have on UK inflation, let’s not forget that Mr Burnham has just spent a few weeks touring the country talking about the elevated cost of living (crisis), and that he is focused on doing what he can to bring those costs down. I am pretty confident that there is more he will want to do to insulate households from further cost of living increases, and that might include, for example, taking VAT off the gas price, which would clearly reduce the impact of higher gas prices through the winter and would of course keep inflation down too.

Although the increase shown above looks ugly on a one-year view, the second chart, shown below, puts this most recent increase in context by comparing it with what happened after Russia invaded Ukraine back in 2022.

Clearly prices are currently elevated, but they are nowhere near the extreme levels reached back in 2022.

Vigilantes? No, Treasuries

Whilst it is impossible to prove, I do not share the consensus view I hear so frequently now that elevated gilt yields are a reflection of the bond market’s displeasure with the incumbent government’s fiscal policy. Whilst I share the view that we have a spendthrift government that is incapable of controlling government spending (see below), the bond vigilante argument just doesn’t hold water for me.

In my view, ten-year yields are elevated in the UK simply because ten-year Treasuries are too, and that is because inflation in the US is at 3.4% (it is 2.9% in the UK) and the new Fed chairman has just given a speech which indicates he is concerned about this. Given the market now thinks that an increase in Fed funds at the September meeting is more likely, that has been reflected in a higher ten-year Treasury yield, which has dragged gilt yields with it.

Interestingly, today (Thursday) government bond markets are in a somewhat better mood and yields have fallen again – the US ten-year to 4.76% and the equivalent gilt to 5.16%, a 40bp premium. If anyone doubts that this close relationship exists, they might examine the chart below.

The fiscal squeeze

Whilst I do not buy the vigilante argument, I do accept that higher gilt yields will impose all sorts of pressures on the new prime minister and his chancellor. Over the next eight weeks (why on earth does it take so long?) the OBR will be formulating its forecasts, which will frame what happens in the budget at the end of October.

Higher gilt yields will result in higher debt funding cost assumptions, which will, amongst other things, shrink the scope of what the chancellor can do whilst remaining within the fiscal rules. Once again, I suspect that because this government cannot control spending, their solution to this problem, as it always is, will be to raise taxes again, just as they did in 2024 and in 2025.

I bumped into this unpleasant reminder of Rachel Reeves’ first budget this week when I was researching this piece. It is the OBR’s summary of her first budget’s impact:

Almost £70bn a year for five years is £350bn. Not satisfied with this egregious burden, last year’s budget left spending in 2029/30 a further £32bn a year higher than the OBR had forecast in March 2025, and it seems that Mr Burnham and his Chancellor will keep up the tradition by increasing spending again in October.

Which makes it all the more ironic that at his first PMQs this week Mr Burnham not only criticised the Tories for overseeing a rising debt to GDP level (which is true) but then went on to profess that his government would be “grounded in fiscal responsibility”. More accurately, this government is grounded in fiscal incontinence, but I was also fascinated with the criticism that the Tories had presided over a rising debt to GDP ratio. The implication being that the Tories had spent too much money, an accusation that sits uncomfortably next to his accusation that the Tories had presided over fourteen years of austerity. Which is it, I wonder, because it cannot be both?

Most ironic of all is that the government’s original excuse for massively increasing spending and tax was to make up for years of Tory neglect and under-spend on public services. But now the PM is criticising the previous administration for presiding over a rising debt to GDP ratio. You could not make it up!

What to look out for next week

There are a few things to be aware of. First, the Chancellor will be giving a speech on Monday, where I presume he will be talking about tough choices and fiscal probity etc. I am not holding my breath for a confession that the Labour government has spent and taxed too much, and that the answer to the challenges he confronts will be to reduce both. Instead, I suspect there will be dark hints of what Andy Haldane described as the hat-trick – the third budget in a row that will increase spending and tax. (By the way, Andy was advising the government to avoid the hat-trick!)

Then on Friday we get GDP data, which I will be taking a very close look at. If the numbers come in in line with consensus, it will be confirmed that so far in 2026 the UK is the fastest growing economy in the G7.

In the US there is the usual diet of labour market data and, at the end of the week, important inflation data that bond markets will be paying close attention to, as I suspect will the Fed chairman.

Thankfully the corporate results diary is still relatively subdued, albeit that quite a few small and mid caps are reporting in the UK.