The Chancellor’s officials have been burning the midnight oil, and the smoke is now visible. Word from Whitehall is that HM Treasury has quietly drafted an emergency budget scenario for the incoming prime minister. This is not a hypothetical stress test.
This is a contingency plan for a fiscal crisis that could erupt within weeks of the handover. The next occupant of 10 Downing Street will inherit a fiscal position that makes Liz Truss’s mini-budget fiasco look like a minor accounting error. Gilt yields are stubbornly high, inflation remains stickier than a toffee pudding, and the bond market vigilantes are circling like sharks scenting blood.
The Treasury’s draft scenario apparently assumes a fiscal tightening of at least £15 billion, drawn largely from spending cuts rather than tax hikes. Why? Because the market’s patience for further borrowing has evaporated.
The yield on 10-year gilts has been oscillating around 4.5 per cent, a level not seen sustainably since the 2008 financial crisis. This is not a reflection of economic strength.
It is a risk premium. Investors are demanding compensation for the UK’s political instability and lack of a credible fiscal anchor. The emergency budget scenario is the Treasury’s way of signaling that the new premier must hit the ground running with a plan to repair the public finances.
But here is the rub. The next prime minister will be either Keir Starmer or Rishi Sunak, barring a political earthquake. Both have made spending commitments that sit uneasily with fiscal rectitude.
Labour’s green prosperity plan and the Tories’ tax-cutting instincts both clash with the reality of a depleted fiscal headroom. The Office for Budget Responsibility’s March forecast showed just £6.5 billion of headroom against the fiscal rules.
That cushion has since been eroded by higher borrowing costs and weak growth. The Treasury’s emergency scenario is a message to the leadership candidates: abandon your pet projects or face a bond market revolt. Capital flight is the ghost at the feast.
Foreign holdings of gilts have been declining for years, and the current account deficit remains stubbornly wide. The UK is dependent on the kindness of strangers to finance its spending. If that confidence shatters, the pound will take a dive and inflation will get a second wind.
The Bank of England’s monetary policy committee will be watching nervously. They have already had to raise rates to 5.25 per cent, and further tightening may be needed if fiscal credibility is not restored.
The new prime minister’s first test will be the emergency budget, likely in late September or early October. The Treasury draft reportedly includes cuts to departmental spending in unprotected areas like justice, local government, and transport. Welfare is also on the table, with tighter conditionality and reduced uprating.
The political pain will be immense. But the alternative is a loss of market confidence that would make the 2022 gilt crisis look like a temper tantrum. The irony is that both main parties have spent the campaign blaming the other for the mess.
But the reality is that the next PM will have no choice but to administer a dose of fiscal austerity. The only question is who will swallow the medicine. The City will be watching the leadership debates with more than usual interest.
The bottom line is simple: the next prime minister inherits not just a country, but a ledger that is bleeding red ink. The emergency budget is the bill that has come due. Let us hope the new tenant of No 10 has a steady hand and a realistic plan.
Otherwise, the gilt market will write one for them.
