Gilt trip: UK government borrowing costs climb sharply

Yields on UK government bonds have surged sharply in recent weeks, driven by market jitters ahead of the Labour government’s first Budget on 30 October. Ten-year gilt yields have jumped from 3.75% in mid-September to roughly 4.2%, raising concerns about the sustainability of government borrowing.

As Chancellor Rachel Reeves prepares to unveil her programme, investors are closely scrutinising the potential for increased borrowing. UK public sector borrowing has already surpassed official forecasts this year and is set to keep climbing. Reeves has confirmed she will revise the Government’s debt target, allowing for over £50 billion more in borrowing while reducing debt as a share of national income. Her new framework, termed ‘public sector net financial liabilities’ (PSNFL), will account for the value of illiquid public assets, such as schools or roads, in the measurement of debt. It will also factor in a wider range of liabilities, including those stemming from public sector pensions.

According to Reeves herself, this framework would “[take] account of the benefits of investment, not just the costs”. This proposal, along with tax increases, would serve to plug the £22 billion hole in government accounts. Reeves has ruled out major tax increases, but the possibility of expanded borrowing to fund public investment is causing concern among bondholders, who fear an oversupply of debt could push borrowing costs even higher.

This is especially worrying in light of previous UK governments’ fiscal missteps. The disastrous “mini-budget” of 2022 under Liz Truss included significant unfunded tax cuts and triggered a sharp spike in gilt yields due to a loss of investor confidence. Although investors generally believe Reeves will avoid similar mistakes, the memory of the market turmoil caused by Truss lingers, keeping investors on edge ahead of the Budget.

Global economic factors, combined with domestic inflation pressures, have widened the spread between UK gilt yields and those of other major economies

While concerns over the incoming government’s fiscal policy play a role in rising yields, global economic factors have also contributed to the spike. The strong performance of the US economy, notably in retail sales, has led to higher yields on US Treasuries. This trend has influenced global bond markets, including the UK, as higher yields increase the relative attractiveness of US government debt.

These global economic factors, combined with domestic inflation pressures, have widened the spread between UK gilt yields and those of other major economies. The gap between UK and German 10-year bond yields has widened to roughly 1.94%, marking its highest level since August 2023. This can be attributed to the Bank of England’s (BoE) more cautious approach to cutting interest rates than other central banks, such as the European Central Bank (ECB). The OECD recently forecast that the UK will experience the highest inflation in the G7 this year and next, further complicating the outlook for gilt markets and keeping borrowing costs high. However, BoE governor Andrew Bailey has said the central bank will become more “aggressive” in cutting interest rates if inflation continues to fall. British inflation has already dropped to 1.7% in September, below the BoE’s 2% target.

If the rise in borrowing costs can then be attributed to other economic changes, market uncertainty over Reeves’ fiscal policies may be overblown

If the rise in borrowing costs can then be attributed to other economic changes, market uncertainty over Reeves’ fiscal policies may be overblown.  In fact, many investors remain optimistic about the gilt market. With many market participants expecting Reeves to handle fiscal policy more responsibly than her predecessor, there is a belief that the bond market will stabilise once the Budget is unveiled. According to a Reuters poll of investors, 10-year gilt yields are set to fall to roughly 3.85% by the end of the year. Analysts at Goldman Sachs, Blackrock, Aviva Investors, and Amundi have recently increased their exposure to UK gilts, expressing confidence in Reeves. The chancellor herself has also issued assurances to quell investors’ concerns, promising “prudent, sensible investments” and “guardrails”.

While gilt yields have surged, the movement does not necessarily indicate an impending crisis. Rather, it reflects a combination of fiscal uncertainty ahead of the Budget, inflationary pressures, and global economic dynamics. What remains to be seen is how Reeves will strike the right balance between her commitment to increased public investment and the need to reassure markets about fiscal discipline.