Client Update - 4th July 2025

What a grim week for the chancellor Rachel Reeves. It did not even start very well for her, as she was given a harsh reminder of the fragility of the public finances when the UK’s fiscal watchdog admitted on Tuesday that its forecasts — upon which her economic strategy rests — have repeatedly been too optimistic.

The government’s capitulation on welfare reform this week has created a new “black hole” – this time only a meagre £5bn – at a time when the Office for Budget Responsibility admitted it had regularly underestimated how much the government would borrow over a five-year horizon, while overestimating growth. The analysis in the OBR’s “forecast evaluation report” included outlooks it has issued since its inception in 2010. Any cuts to OBR forecasts ahead of Reeves’ autumn Budget would add to her mounting fiscal and political woes.

The government’s £5bn welfare U-turn, which averted a massive backbench rebellion, followed Reeves’ grudging decision to rewrite her plan to cut winter fuel payments to pensioners, costing her an additional £1.25bn. Labour MPs, sensing Reeves’ political weakness, are also pushing for the scrapping of the Conservative-era two-child benefit cap, which would cost the Treasury another £3.4bn. Ministers confirm the issue is on the table and a decision will come in the autumn. Those policy changes would burn through almost all of the £9.9bn of “headroom” that Reeves allowed herself against her fiscal rules in her Spring Statement in March.

Government borrowing has on average exceeded the official forecast by 3.1 per cent of GDP on a five-year horizon, the OBR report found. This reflects both the OBR’s excessive optimism on GDP figures and the legal requirement that the agency bases its projections on government plans, it said. What else could stretch the fiscal rules? Efforts to sustain good relations with Donald Trump could also prove costly for the UK. British officials admit that Canada’s decision to scrap its digital services tax in an effort to smooth trade relations with the US president could lead to renewed pressure on the UK to ditch its equivalent tax, which targets American technology companies. The digital levy is on track to yield £1.2bn a year for the Treasury by the end of the parliament, according to OBR forecasts.

This all ended up with a very difficult session in Parliament on Thursday and Sir Keir Starmer didn’t even come to her support, failing to answer the opposition leaders question if she would still be chancellor come the end of the year. She has, however, found one friend through all of this though – the UK bond market. As news broke that her future may be becoming untenable, UK gilt yields rose quickly, pushing up the cost of UK borrowing.

This may ultimately be useful to Reeves, or her successor. It shows that the bond market is every bit as sensitive – and probably more so – than it was when Liz Truss launched her ill-judged fiscal event in 2022. It should also give pause to those tempted to believe promises from other parties to simultaneously cut taxes and raise spending. There is no magic money tree. 

It is also an irritating distraction, potentially raising the cost of borrowing at a time when Labour has little headroom. The irony of this whole episode is that recent falls in the gilt yield would probably have given Reeves the headroom she needed to pay for at least some of the benefit rollback. Now her situation is worse than ever. There is not an inch of flexibility in the UK’s finances and every rebellion sets her sums back once again.

Reeves’ fate notwithstanding, this shows an important truth about UK borrowing – there is absolutely no wiggle room. The Chancellor has come under pressure to break her fiscal rules to fund, say, defence spending, or encourage growth, but yesterday’s bond market moves make it clear that the bond market won’t weather it. Do have a good weekend.