At just after 12.30pm on Wednesday, the machine will be listening, the trading algorithms ready, and billions of pounds of buy-and-sell orders stacked up awaiting Rachel Reeves’s budget.
For the first time on the London trading floor of Deutsche Bank, a custom-built artificial intelligence tool will tune in to the chancellor’s speech. It will transcribe her words, spot shifts in tone and spit out alerts when the numbers deviate from expectations.
“As we get it, in real time, we’ll be able to decipher it,” says Sanjay Raja, the bank’s chief UK economist. The natural language model has been trained on the entirety of Reeves’s recent public appearances: media interviews, conference speeches, the spring Office for Budget Responsibility (OBR) forecasts and last year’s budget. All with the aim of giving the bank an edge in one of the most heavily anticipated budgets in recent history.
“There are some high, high, high, expectations going into 26 November, for the budget to deliver on the part of the City,” says Raja.
This is the age of the bond market budget. After an explosion in government borrowing over the past decade; a sharp rise in debt interest costs, and with the scars of the Brexit vote and Liz Truss’s mini-budget still fresh, how the market reacts is critically important.
Photograph: David Levene/The Guardian
For months, Reeves has been schmoozing the biggest players in the £2.7tn UK government debt market, including hosting the bosses of Goldman Sachs and JP Morgan in Downing Street, in a bid to ensure smooth passage for her multibillion-pound tax and spending plans.
What the market thinks has been pored over by commentators throughout the budget buildup, anthropomorphising the electronic transactions executed on trading systems the world over. The fear is that upsetting the market could trigger a sell-off – driving up borrowing costs for the government, mortgage holders and businesses. That could trigger a domino effect that in turn costs Reeves and Keir Starmer their jobs – potentially paving the way for a new Reform UK-led government.
Reeves was given a taste of the bond market’s power earlier this month when government borrowing costs spiked after it emerged she had ditched plans for a manifesto-busting increase in income tax.
In reality, the market for UK government bonds, – known as gilts – is not of course controlled by a single, shadowy figure, but rather a panoply of institutions and people, sat behind trading desks across the City, Canary Wharf and other financial centres.
On the trading floor of the FTSE 100 insurer Phoenix Group, with views overlooking London’s Old Bailey, Samer Refai will be ready behind his Bloomberg terminal. With £300bn of assets under its control, including billions of pounds-worth of gilts held to back the pensions, savings and life insurance of its 12 million customers, budget day is a big deal.
“You must have heard the famous quote from Bill Clinton’s adviser,” says the firm’s head of macro markets. (James Carville, the former president’s chief strategist, quipped in 1993 that reincarnation as “the bond market” would give him more power than any president or pope).
“It really does intimidate people. Nothing moves the government quicker than the bond market,” he says.
“You can tell that the sort of – the animal, or the beast, that you’re interacting with is obviously influential.”
In recent years, the power of the bond trader has ballooned amid an explosion in government debt and borrowing costs across advanced economies driven in part by rising inflation and weak growth. While the UK is not alone, investors say it has unique challenges.
After a succession of economic shocks and a history of running annual budget deficits, Britain has racked up a debt pile worth more than £2.7tn – close to 100% of national income. Inflation is at the highest rate in the G7, and continuous speculation over the government’s fiscal position has not helped.
At the same time, the Bank of England is selling gilts held under its crisis-era quantitative easing scheme. Alongside issuance to cover government borrowing, vast gilt volumes are flooding the commercial market.
Historically, pension funds hoovered up most of the debt. But the end of defined benefit or final salary schemes has steadily sapped demand. More overseas owners have stepped in, and account for about a third of the market.
The OBR warns this could make the UK more vulnerable. Overseas investors could readily choose to buy elsewhere. For Reeves, this will be front of mind in keeping the bond market onside.
Against this backdrop, Britain’s annual debt interest spending has reached £100bn – representing £1 out of every £10 spent by the Treasury. That is adding to budget pressures as the costs of repairing battered public services and supporting an ageing population mount.
The yield – in effect the interest rate – on 10-year bonds has reached 4.5%, the highest level in the G7. The 30-year is close to its highest point since 1998.
Simon French, the chief economist at Panmure Liberum, says part of Reeves’s strategy is to coax yields back down to shrink this interest bill. Getting Britain back to the middle of the pack could be worth billions of pounds a year.
“Comparing the UK to the G7 is like saying who is the most drunk at the party. [But] it’s a pretty heavy inroad into your fiscal gap. That is the opportunity.”
There could be a “dullness dividend” from getting interest rates down, he says, the opposite of the “moron premium” under Truss. “Avoid self-harm, and there’s a rally.”
To do so, Reeves will be required to tackle inflation at the same time as filling a potential £20bn budget shortfall. Raising taxes and cutting spending could make that tougher – especially without crushing economic growth, or breaking Labour’s manifesto promises.
How much more debt investors will be asked to stomach will be a key budget moment. The City is looking for Reeves to rebuild a hefty margin of headroom against her fiscal rules. That would limit the deficit, and with it future gilt auctions.
“You’re waiting for the mic drop on the current budget rule. That’s what we’re looking for,” says Moyeen Islam, the head of UK rates strategy at Barclays.
In the spring, Reeves left £9.9bn in reserve as a buffer. But this is expected to have been more than demolished by higher borrowing costs, welfare U-turns, and a downgraded OBR productivity forecast.
Investors are hoping for a figure above £20bn, he says. “That would be very gilt positive.”
However, a political strategy centred on pleasing City financiers is not entirely comfortable territory for Labour, especially when many of those investors want Reeves to get a grip on rising welfare spending.
Geoff Tily, senior economist at the Trades Union Congress, says the City backed the Tories’ 2010s austerity drive. “That damaged, rather than repaired, the public debt.
“Our view is that markets are not always rational. But markets do care about growth. And there is evidence that they would look favourably on policies that set the economy on a better course.”
Investors had been led to expect a manifesto-busting income tax rise. Doing so would be the simplest way to raise billions for the exchequer, rather than through a smorgasbord of smaller measures that could be tricky to implement.
“We had underestimated how difficult a choice that is, and how high that hurdle [a manifesto breach] is for a chancellor – any chancellor,” says Islam.
Perversely, this could smooth Wednesday’s reaction, as many investors fear Reeves being ejected from No 11. “The market has learned that sometimes those decisions are more complex and more nuanced than perhaps we had thought.”
On Panmure Liberum’s trading floor, Marco Varani still predicts choppy trading conditions.
“What you really crave in this industry is movement, volatility. There is more business. Days like Brexit and the first days of Covid, that’s like when it’s peak frenzy. I mean, it was utter carnage.”
As soon as the Bloomberg headlines on Reeves’s speech land, the head of retail trading expects a rapid reaction. “You can see the gilt market got a little bit nervous with the flip-flopping around. There will be a lot of volatility.”
During the speech, the first gilt moves, currency swings and shifts in UK-listed company shares are expected to be mostly driven by “fast money” – the City slang for hedge funds.
Their involvement in the gilt market has doubled from 15% of trades in 2018 to roughly 30%, according to the Bank of England. Much of this is driven by borrowing-fuelled bets among a small number of firms.
However, the ultimate verdict could take several days. How Threadneedle Street proceeds with its interest-rate cutting path – expected weeks later on 18 December – is key. As will be Britain’s growth trajectory and global conditions.
Anthony O’Brien, the head of market strategy at Phoenix Group, says: “The market’s interpretation on day one should never be seen as ‘that’s what the market’s telling you’. To a large extent it is just people who are caught offside. And perhaps it does take a few more days afterwards.
“Ultimately it is economics which drives the valuation for gilts. We need to concentrate on inflation coming down. Let’s just get this uncertainty out of the way.”
