How not to blow up your bond market

Politicians on both sides of the English Channel are about to be tested on the first rule of bond markets: There’s a big difference between borrowing lots of money in a suit and borrowing lots of money in a clown outfit and brandishing a supersized water pistol. The former is a good idea.

The stability in sterling and in gilts prices in the run-up to the UK election suggests that investors are pretty sure Rachel Reeves understands this important distinction. The betting right now is that if, as opinion polls suggest, the former Bank of England economist becomes chancellor from July 5 and if, further down the line, she decides to raise bond issuance targets, markets will cope just fine. Borrowing costs might rise, but in all likelihood, not disastrously so.

On France, investors are less confident. French government bonds have weakened considerably since President Emmanuel Macron announced a snap legislative election, the first round of which takes place on Sunday. Fund managers know that by July 8, the country could have a prime minister from the extreme left or, as polls suggest is somewhat more likely, from the extreme right. A second-round tie-up between those two extremes, without any role for Macron’s party, would be the least market-friendly outcome, as UBS notes. Discussions with clients suggest the gap between French and safer benchmark German government bonds “may test 1990s levels in this scenario”, the bank says.

The grim spectre hanging over both nations’ finances is Liz Truss, whose assault on UK markets alongside her chancellor Kwasi Kwarteng in late 2022 persists as a textbook case of what not to do. “People say we’ve seen a Liz Truss moment and no one else wants a Liz Truss moment, but the market knows it can happen,” said Rob Dishner, a senior portfolio manager at Neuberger Berman. “Any plans will need to make fiscal sense or the markets will be quick to punish them.”

With that in mind, how does the discerning new government avoid tipping fickle markets over the edge? Step one, to be extremely generous to Kwarteng, is to be lucky. If you squint, sink a stiff drink and stand on your head for a few moments you can just about believe that his efforts coincided with a broad decline in bond prices, and that the wobble he induced therefore pushed on an open door. (For what it’s worth, my colleague Gillian Tett described that line of thought at the time as “bollocks”, and I agree with her.)

Step two is to use an external, impartial body to check your sums — a stage that Kwarteng and Truss disregarded by omitting to seek the input of the Office for Budget Responsibility. And step three is to maintain a certain level of respect for markets, the limits for how far they can be pushed and an understanding of what can go wrong if they short-circuit. 

The key here is that borrowing, in and of itself, is not necessarily a problem. More important to investors is how any borrowing is done, how it is presented and what it is for. “We could have a more sensible debate around debt levels — it does matter where the spending goes,” said Tristan Hanson, a fund manager at M&G Investments.

One encouraging sign is that Marine Le Pen’s Rassemblement National seems to have heeded the warning from Truss’s market immolation. Jean-Philippe Tanguy, an RN MP who works on economic policy, told the FT he has been telling businesses and investors that the party “will hold the line on deficits and present a credible plan”. Crucially, he added, “the markets will be severe on us, so we really have no choice but to do so”. 

Setting aside any aversion to the RN’s broader agenda, analysts are taking this as a sign that the party is willing to soften the edges of policy goals to stay on track. “We believe the RN will present a moderate front while in government to demonstrate to the French people that RN can govern as well as, if not better than, the mainstream political parties,” wrote Nomura’s analysts in a note. “In our view, the desire to act like adults when discussing with businesses and market participants will go a long way to assuage fears.” The prospect of lengthy bickering with Brussels is unhelpful, and sets up France as the new Italy — prone to bouts of bond weakness on budget bust-ups. But the RN’s recoiling from enthusiasm to leave the EU certainly helps. 

Overall, the impending flurry of European democracy in action gives investors much more reason to fret over France than the UK. For one thing, the result of the French vote is still highly uncertain. In addition, the country has a much larger slice of its debt maturing in the next five years than the UK, Dishner calculates, which means it will feel the heat from potentially higher borrowing costs earlier. Plus, around half of French government debt is held overseas — a tally high enough to leave the country vulnerable to jitters, he adds.

An assumption that extra borrowing is impossible is the wrong conclusion to draw from the experience of 2022. But political powers need to demonstrate the competence that keeps markets on side, and to eschew oversized shoes and multicoloured overalls in their wardrobes.

katie.martin@ft.com