Chancellor’s fiscal plans under pressure as UK bond yields surge

Rachel Reeves may have spoken too soon about her ‘non-negotiable’ fiscal plans laid out in the October 2024 budget. Stubbornly high bond yields have placed significant strain on these plans, with 30-year yields reaching 5.13% and 10-year yields hitting 4.56%.  The UK economy is also exhibiting a concerning trend of borrowing. For example, borrowing during the first nine months of the 2024 fiscal year climbed to £129.9 billion, an £8.9 billion year-on-year increase. The chancellor may have little choice but to rethink her fiscal strategy. 

This turmoil in bond yields cannot be solely attributed to domestic policy missteps. Unlike the self-inflicted catastrophe following the October 2022 mini-budget under Truss, this recent increase is heavily influenced by global market dynamics. A key factor has been the performance of US Treasury yields.  

The national debt, now standing at £2.8 trillion – approximately 100% of GDP – has left the government with limited fiscal flexibility

Trump’s re-election, and his proposed slate of inflationary policies, such as blanket tariffs and mass deportations, have led to US Treasury yields spiking: 10-year bonds peaked at around 4.8% in mid-January. As US bond yields became more attractive to investors, this led to declining appetite for UK gilts and other international bonds. This shift in demand has created upward pressure on global bond yields, including those in the UK. 

The Labour government, however, cannot plead innocent. Domestic economic challenges have exacerbated the bond market turbulence. According to KPMG’s Economic Outlook, inflation is expected to linger into 2025, averaging around 2.4%. Although GDP growth is forecast to improve to 1.7% in 2025 from 0.8% in 2024, it remains below the 2% benchmark for healthy growth in developed economies. Alongside this are concerns about the weakened pound, which has lost value against most major currencies. This has raised doubts about the UK’s economic stability and fiscal credibility, making investors wary of UK gilts. 

Goldman Sachs Research … predicts that 10-year gilt yields will fall from the current 4.56% to around 4% by the end of 2025

The national debt, now standing at £2.8 trillion – approximately 100% of GDP – has left the government with limited fiscal flexibility. Large deficits are expected to persist, requiring further gilt issuance, which may create a self-reinforcing cycle of higher borrowing costs and increased market turbulence. The founder of Bridgewater Associates, hedge fund titan Ray Dalio, has warned of a potential “debt death spiral”, where borrowing becomes necessary to service loans, creating an unsustainable feedback loop. 

Despite the mounting challenges, there are glimmers of hope for the UK bond market. Goldman Sachs Research has projected a gradual easing of bond yields, driven by potential policy adjustments from the Bank of England. The investment bank predicts that 10-year gilt yields will fall from the current 4.93% to around 4% by the end of 2025. This expectation relies on the Bank of England’s ability to stabilise the market through a more accommodative monetary stance, including potential interest rate cuts as inflation moderates.  

Recent data from Dan Hanson, chief UK economist at Bloomberg Economics, supports this optimistic outlook. Hanson highlights a significant slowdown in the UK’s trend growth rate, which has halved, from 2.5% in the 1959-2009 period to 1.2% currently. Though this trend poses a significant challenge, it may also create conditions conducive to lower interest rates. As the economy continues to grow below potential, the Bank of England may find room to cut its policy rates without risking inflationary pressures.  

To navigate this period of volatility, the UK government must carefully balance fiscal prudence with economic stimulus. Restoring investor confidence will require demonstrating long-term plans for debt reduction while maintaining short-term flexibility to enhance growth. As the global and domestic pressures that have driven bond yields higher begin to ease, the UK bond market may find stability in the medium term. However, the path forward will depend on a combination of careful policy decisions, economic resilience, and the impact of global market trends.