Market Review 7th July 2025

Everything you need to know, Simplified!

Summary

• The UK faces an acute fiscal dilemma: high borrowing costs, a persistent primary deficit, and no political appetite for meaningful spending cuts or tax hikes, making debt stabilisation an increasingly uphill battle

• Gilt yields spiked after an emotional Prime Minister’s Questions (PMQ) before retracing; gilt markets remain vulnerable to fiscal policy and face additional technical headwinds

• In the US, Trump’s ‘One Big Beautiful Bill Act’ passed, lifting the debt ceiling by $5trn, leaving deficits stuck near 7% of Gross Domestic Product (GDP) with no plans to cut spending or raise taxes

• Markets are watching the 9 July tariff deadline, with Trump set to announce reciprocal tariffs above 10% for multiple countries, continuing an upward trajectory in trade restrictions after Vietnam’s recent tariff deal.

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Market Review

Chancellor Reeves stuck between a rock and two hard places

Being Chancellor of the Exchequer today is no enviable job. Reeves has inherited an economy caught between a rock and two hard places. Borrowing costs are high, and government spending continues to outstrip revenues, leaving the UK with wafer-thin fiscal headroom and likely to breach its own borrowing rules. The deficit must be cut, either through spending cuts or tax hikes.

Yet the options are politically toxic. The Labour government has no appetite for meaningful spending cuts (the rock), having already abandoned planned welfare reforms and cuts to the winter fuel allowance. The public has no appetite for further tax hikes (hard place one) after the initial round. Meanwhile, financial markets have no appetite for persistent deficits (hard place two), with the shadow of the Truss episode continuing to haunt the gilt market.

After an emotional PMQs on Wednesday, gilt yields suffered one of their sharpest jumps since Truss was Prime Minister, with the 10-year spiking 0.21% to 4.63% after Starmer refused to confirm that Reeves would remain in her role. Yields later retraced most of those losses, ending the week only 0.05% higher at 4.55%, but the vulnerability of the gilt market was on full display.

Although gilt yields remain high relative to other developed markets, their yield per unit of volatility has been among the lowest, making gilts unattractive from a risk/reward perspective. Market volatility is amplified by several structural factors. For one, the market has become more speculative and leveraged, as exposed during the Truss crisis – which was really a leveraged Liability-Driven Investment crisis.

But beyond technical elements, the UK faces a deeper structural dilemma. Both the UK and US run large deficits and carry heavy debt burdens, but the US enjoys stronger productivity growth and the privilege of issuing the world’s reserve currency. For the US, higher growth, innovation, and lower borrowing costs make outgrowing the debt burden a more viable option. For the UK, the prospect of outgrowing its debt burden is more remote. With debt-to-GDP near 100% and real gilt yields around 1.5%, economic growth needs to exceed this level simply to stabilise the debt ratio – a hurdle the UK hasn’t consistently cleared, with growth averaging just 1.41% since the Global Financial Crisis. Worse, this calculation also assumes a balanced budget. With the UK’s primary deficit still well above 2%, outgrowing the debt is not an option, as it was post-World War 2.

Bond vigilantes are back, and any perception that Labour will deprioritise fiscal consolidation only heightens gilt sensitivity. In contrast, treasury markets remain anchored by a stronger economy and deep global demand for US dollars and US debt. Gilts simply don’t enjoy that privilege.

‘One Big Beautiful Bill Act’ (OBBBA) passes

The OBBBA passed Congress last week, with President Trump inking the paper on the 4 July national holiday. After late-night drama in the Senate and House, Vice President Vance cast the tie-breaking vote.

The bill lifts the debt ceiling by a further $5trn, giving the Treasury immediate room to issue new debt. Markets reacted calmly, but the fiscal implications remain concerning. Even assuming robust tariff revenues and solid growth (if there is a growth shock the deficit could perceivably rise to double digits), the deficit is likely to remain around 7% of GDP, with no meaningful plans to cut spending or raise taxes.

Trump’s failure to address the budget deficit leaves Musk’s recent criticisms well-founded. Without a plan to reduce spending or raise taxes, any material reduction in the deficit now seems reliant on falling borrowing costs. This helps explain Trump’s ongoing spat with Federal Reserve Chairman Powell.

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The week ahead

Wednesday: Tariffs come back into effect

Our thoughts: Markets will be watching the 9 July tariff deadline, when President Trump is expected to announce reciprocal tariffs above 10% for multiple countries, effective from 1 August.

Recent moves underscore an upward trend in tariff rates rather than any de-escalation. Last week’s trade deal with Vietnam saw its tariff rate rise from 10% to 20% on most goods, and to 40% on Chinese-origin goods re-exported via Vietnam. While this was below the threatened 46% rate, it still represents a tightening of US trade policy.

Further sectoral and country-specific tariffs remain in the wings, with negotiations proving difficult for some key trading partners. The administration appears set on leveraging higher tariffs to extract concessions, particularly targeting Chinese trans-shipments through third countries. Markets will be alert to any retaliation, escalation, or macro spillover effects from these announcements.

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