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The UK Government vs the Bond Market

In a nutshell

When UK government bond prices fall and yields rise, politicians and media often warn that “the markets are losing confidence” and the government might not be able to afford its debt. However, this misunderstands how the system actually works. The UK government pays bondholders in pounds that it creates through the Bank of England, it literally cannot run out of money to pay them. Rising yields primarily hurt the bondholders themselves, like pension funds, whose existing bonds lose value. The real constraint isn’t the government’s ability to pay, but the political pressure that comes from market volatility and the economic disruption it can cause to financial institutions holding the bonds.

The full explanation

The relationship between the UK government and the bond market is widely misunderstood, leading to unnecessary fears about government “bankruptcy” and misguided policy decisions.

  • What Bonds Actually Are: UK government bonds (gilts) are simply promises to pay a fixed amount of pounds at specific dates. If a private sector institution buys a 10-year gilt it is altering the composition of its assets, rather like moving money from a current account to a savings account. A bond is attractive because it offers a rate of interest but the funds to buy the bond have already been injected into the monetary system by government spending. The government cannot “run out” of its own currency any more than a football stadium can “run out” of points to put on the scoreboard.

  • Why Yields Rise and Fall: Bond yields move based on various factors: expected inflation, central bank policy, economic growth prospects, and investor sentiment. When yields rise (prices fall), it often reflects investors demanding higher returns due to inflation expectations or risk perceptions, not an inability of the government to pay. The Bank of England’s interest rate policy strongly influences these yields, for example, if bond traders expect the MPC at the Bank to raise short-term rates interest rates they will require higher long term rates on bonds and will reduce their offer prices on new bond issues accordingly. However, there is no operational need for bonds to be sold, they simply constitute the offer of an interest bearing asset to the private sector.

  • The Real Impact of Rising Yields: When bond prices fall, the main losers are current bondholders, pension funds, insurance companies, and other financial institutions. These institutions can face funding problems, as happened during the 2022 “gilt crisis” when pension funds using complex hedging strategies faced margin calls. This creates genuine economic instability, but not government insolvency. In any case, the Bank of England can always correct market instability by buying bonds to prevent a fall in prices or selling to prevent a rise in prices. If the Bank doesn’t act quickly enough this is a failure of Bank policy.

  • Political vs. Financial Constraints: While the government faces no financial constraint in paying bondholders, it does face political constraints. Rising yields create headlines about “market discipline” and can pressure politicians to cut spending or raise taxes to appear “credible” to markets, even when this may be economically counterproductive. However, such headlines reflect the authors’ ignorance, not reality.

  • The Bank of England’s Role: As noted above, the Bank of England can always intervene to stabilize bond markets if it chooses, as it did during the 2022 crisis. This intervention capability demonstrates that yield spikes are ultimately controllable policy choices, not inevitable market forces that bind the government’s hands.

Frequently Asked Questions (FAQ)

  • But didn’t the UK nearly go bankrupt in 2022 when gilt yields spiked? No, the UK government was never at risk of bankruptcy. The crisis occurred because certain pension funds had used risky financial strategies (liability-driven investments) that required them to post additional collateral when yields rose. The Bank of England intervened to prevent a fire sale of gilts that could have destabilized the broader financial system. This was a financial stability issue, not a government solvency crisis.

  • If the government can just create money to pay bondholders, why issue bonds at all? Bonds serve several purposes beyond funding government spending. They provide safe assets for pension funds and financial institutions to hold; they help the Bank of England implement monetary policy; and they offer a way for people to save with guaranteed returns. In a modern economy, these functions are valuable even though they’re not necessary for government financing.

  • Don’t higher yields mean the government has to pay more interest, making debt unsustainable? Higher yields on new bonds do increase future interest payments, but this doesn’t create a sustainability problem for a currency-issuing government. Interest payments are made in pounds created by the Bank of England. The constraint is whether paying higher interest creates unwanted economic effects (like inflation), not whether the government can “afford” the payments.

  • What about the Liz Truss budget crisis, didn’t that prove markets can discipline the government? The Truss crisis demonstrated that rapid policy changes can create financial instability, particularly when they conflict with Bank of England policy. Markets weren’t “disciplining” government finances, they were reacting to the prospect of fiscal expansion combined with monetary tightening, which threatened financial institutions holding long-term gilts. The political response came from the real economic disruption this caused, not from any government funding problem. As noted above, when the Bank of England intervened and the ‘crisis’ was over.

  • If bond markets can’t really constrain the government, why do politicians seem so afraid of them? Political fear of bond markets stems from several factors: genuine concern about financial stability effects; misunderstanding of how government financing works; ideological preferences for smaller government; and the political convenience of blaming “market discipline” for unpopular spending cuts. Media coverage often reinforces these misunderstandings by using household budget analogies.

  • Could bond yields rise so high that markets refuse to buy government debt? In theory, if absolutely no one wanted to buy government bonds, the Bank of England could buy them all. Japan’s central bank now owns about half of all Japanese government debt. This shows that market “strikes” against government debt are ultimately unsustainable.

  • What about international investors, couldn’t they dump UK bonds and crash the pound? International investors can indeed affect exchange rates, and a falling pound can create inflationary pressures. However, this is different from preventing the government from paying its debts. The government might face trade-offs between exchange rate stability and domestic policy goals, but it cannot be forced into insolvency by foreign investors selling bonds. Interestingly, at time of writing the UK was the second highest holder of US Treasury bonds, something which is rarely mentioned. The market for the pound is very deep and although it tends to fluctuate in value (like all major currencies) fears of a ‘crash’ reflect a failure to understand floating exchange rate dynamics.

  • This sounds like you’re saying governments should ignore bond markets entirely. Isn’t that reckless? Not at all. Bond market movements provide useful information about economic conditions and policy effects. Sharp rises in yields can signal a preference of bond traders for shorter term debt. The key insight is that the government has more options than commonly believed. It is not subject to market “discipline” but can choose how to respond based on broader economic considerations.

  • Why don’t more politicians and economists understand this? Several factors contribute to the misunderstanding: economic education often focuses on theoretical models rather than institutional realities; the complexity of modern financial systems obscures basic operational facts; and there are political incentives to maintain beliefs about market constraints on government action. Additionally, the system works so smoothly most of the time that few people need to understand the underlying mechanics.