Bond Markets Could Compel Rachel Reeves to Propose a Secondary Budget in 2025

City investors are watching Chancellor Rachel Reeves closely ahead of the 2025 budget, hoping she creates more fiscal headroom to ensure economic stability. Concerns are mounting that disappointing her fiscal plans could trigger volatility in the bond markets and potentially force the government to deliver a secondary budget to regain investor confidence.

David Zahn, head of European fixed income at Franklin Templeton, warns that the greatest risk surrounding the upcoming budget is a negative reaction from the bond markets. Should investor disappointment drive up UK government bond yields, the Chancellor might face pressure to respond with swift fiscal adjustments. Zahn notes that a substantial increase in the yield on 10 year or 30 year bonds to six percent would be unsustainable, risking a vicious cycle for government borrowing. Currently, UK 30 year bond yields stand at 5.35 percent, with earlier peaks reaching nearly 5.75 percent. Ten year bond yields are around 4.53 percent.

Zahn identifies a lack of decisive spending cuts as a factor likely to deter bond investors from supporting government debt. Without meaningful action on either taxes or expenditure, markets are unlikely to reduce borrowing costs by buying more UK gilts. Last week, government bonds were sold off after reports that Reeves abandoned plans for a significant increase in income tax, a move some investors argue would have reassured markets about fiscal discipline.

Instead, the budget may include a freeze in tax thresholds, with estimates suggesting this could raise around £10 billion annually as wage growth pulls more workers into higher tax brackets. There is also speculation about potential increases in multiple smaller taxes, as the Chancellor seeks to balance fiscal constraints with political sensitivities.

With only about £10 billion of fiscal headroom previously available, the Treasury is particularly vulnerable to negative market reactions or shifts in economic forecasts. Zahn believes that markets would welcome an increase in headroom to more than £20 billion, helping the government retain credibility with investors. He also indicates that any tax increases this year are likely to be repeated, given the broader fiscal challenges facing the government.

Political factors may also play a role in market movements. James Smith, developed markets economist at ING, highlights that a dip in Labour’s polling and internal party pressures on Prime Minister Keir Starmer could inject additional uncertainty. Recent memories of the mini budget crisis under Liz Truss continue to influence sentiment towards UK fiscal policy, and investors remain wary of policy missteps that might undermine economic stability.