UK borrowing costs surge: what would it take to bring them back down?
UK borrowing costs have risen above levels last seen in the financial crisis. We explain the background to this trend, the outlook from here – and implications for investors.
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UK government bond yields have risen to the point where the 30-year gilt yield has reached heights last recorded in 1998. The 10-year gilt is trading at its highest level since 2008.
For both maturities, yields have increased by approximately 1 percentage point, or 100 basis points, over the past year – a significant move in the bond markets.
How did we get here?
Recent volatility in the gilt market can be traced back to Chancellor Rachel Reeves’ first Budget in October 2024. A combination of changing the fiscal guardrails that limit government borrowing, an emphasis on front loading additional government spending (incurring higher spending at the outset of a fiscal period), and a decision to fund this (in part) by raising National Insurance taxes for businesses, significantly contributed to the recent rise in yields.
The Budget sparked concerns that growth could stall while price pressures could re-emerge as businesses pass on the increased payroll tax. This latter concern is pertinent for gilt investors, as the UK economy appears more susceptible to inflation than its peers. Overall, it paints a stagflationary outlook for the UK economy.
Gilts have paid more attention to the inflationary aspect of the Budget, not the hit to growth
Source: Macrobond, Schroders 09/01/2025
Turbulence on January 8
Recent months have seen gilt yields move higher both in outright terms and relative to those in mainland Europe, as investors adjust to the new evolving economic environment. Wednesday’s price action, which saw gilt yields lurch higher still, could be linked to investors’ growing nerves over the long-term debt trajectory of the UK.
In her Budget Chancellor Reeves left just £9.9 billion in fiscal “headroom” (the room to manoeuvre before the long-term fiscal rules are breached). This is wafer-thin in the context of public finances, raising the possibility that she may need to cut spending or increase taxes once again.
This combination of growing fiscal risks, persistent inflation concerns, and worries over weak growth were enough to spook the gilt market. The backdrop of rising US Treasury yields - particularly at longer maturities - had a likely spillover effect on gilts.
A true test of a nation’s economic stability can be observed when rising yields, such as those now seen in the gilt market, fail to support its currency. This was evident with sterling in the last couple of trading sessions, as GBP/USD declined to around 1.23, reflecting a drop of just over 3% in the last month. While the decline has not been as pronounced on a trade weighted basis, a depreciating currency hinders the Bank of England’s (BoE) ability to ease monetary policy due to increased import costs. This dynamic likely contributed to higher gilt yields in recent weeks.
Gilt yields have breached important levels and the corresponding depreciation in GBP is concerning
Source: Bloomberg
What could cause a turnaround?
There are two main catalysts for a turnaround in the current market conditions: intervention or lower inflation data. Intervention could originate from the UK Treasury or the BoE. On the Treasury side, verbal intervention is likely the first step. The Chief Secretary to the Treasury recently reiterated the Government’s commitment to the fiscal rules, but did not provide further details.
Hearing from Chancellor Reeves herself would have offered the market greater reassurance. The Chancellor has ruled out both additional tax hikes and increased borrowing to fund day-to-day expenditures, leaving spending cuts as the only remaining option. While politically challenging, such cuts will be essential to alleviating market concerns. The next logical date for such announcement is the Spring Statement on 26 March.
Regarding the BoE, it successfully stepped in during the mini budget crisis of September 2022. However, the UK pension industry is today less likely to need support at the current level of yields. Nonetheless, the first step would be verbal intervention (which we have not had) reminding the market of the tools at its disposal before any bond buying measures are enacted. There have been suggestions that the BoE should halt its active bond sales via its quantitative tightening (QT) programme. However, it is important to note that these active sales only amount to £13 billion this year compared to £50 billion last year, which is relatively insignificant when juxtaposed with the £300bn being issued by the Treasury.
A further potential catalyst for a reversal in yields is the prospect of improved inflation data. Despite weak growth and cooling labour market, inflation remains too far above target to allow the BoE to cut rates significantly. More evidence suggesting that inflation is falling back towards the 2% target would go a long way in relieving investors’ fears.
Looking ahead
Investors are likely to remain cautious in the near term. Although the market does not appear to consider this a repeat of the mini budget crisis, it is important to acknowledge the difficult fiscal situation, poor growth and limited scope of available solutions. The market is likely to prefer shorter maturities relative to longer term UK government bonds, which are less sensitive (but not immune) to fiscal dynamics and offer an attractive yield to maturity, especially versus global comparisons.
If the Treasury reassures the market or there is further evidence that inflation is falling, either would be taken as a positive. For now, both appear absent.
Two-year yields are less sensitive to fiscal deterioration
Source: Bloomberg
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