Why are UK borrowing costs so high?

The UK’s long-term borrowing costs are the highest among the G7, and the gap with the US has been growing in recent weeks. 

The 30-year gilt yield rose above 5.6 per cent this week to near its highest level since 1998, fuelling renewed warnings from some economists over the sustainability of the UK’s debts.

The 10-year benchmark gilt yield — the more closely followed measure — is also the highest in the G7, although it is some way from levels hit in January. Bond yields move inversely to prices.

What is pushing gilt yields up?

One factor pushing up UK borrowing costs is persistent inflation. Price rises are running close to 4 per cent and the gap with Eurozone price growth has reached its widest in nearly two years.

This has kept the interest rate set by the Bank of England higher than that set by the European Central Bank, as well as restraining rate-cut expectations that could pull bond yields of all maturities lower. 

The BoE’s policy rate stands at 4 per cent, with only one more quarter-point cut fully priced in by traders by the end of next year. The US policy rate is in a range of 4.25-4.5 per cent but with five cuts priced in, while the ECB has already halved its policy rate to 2 per cent.

As a result, short-term UK yields, which are most influenced by changes in interest rate expectations, are “very elevated, more so than elsewhere”, said Peder Beck-Friis, an economist at bond group Pimco. “It mainly reflects the inflation problem that the UK has . . . we have been a little bit surprised by [its] stickiness.”

Why are long-term yields even higher?

While the Bank of England is constrained by inflation from cutting policy rates today, inflation is less of a concern for gilt investors over the longer term: market measures show long-run inflation expectations have fallen this year.

And yet, the UK — like other global bond markets — has seen a growing gap open up between long-term yields and those of shorter maturities. Investors call this a “steepening” of the yield curve. 

One driver of this has been the reversal of central banks’ bond-buying programmes, which for years had helped keep long-term borrowing costs subdued. Some recent upward pressure has come from the Treasury market, where US President Donald Trump’s attacks on the Federal Reserve have pushed the curve this week to its steepest in three years.

But an important factor has been a record level of sovereign borrowing across the developed world, with debt issuance among the OECD high-income group of countries expected to reach $17tn this year, up from $14tn in 2023.

This has created a supply-demand imbalance, investors say. 

“It is a large amount of government debt [issuance] chasing the same cash globally,” said Tomasz Wieladek, chief European economist for fixed income at asset manager T Rowe Price.

Why is the UK particularly suffering?

Some of the differences in long-term borrowing costs reflect long-running dynamics, such as Germany’s reluctance to borrow, which has kept Bund yields low.

But many investors believe the UK is being charged a so-called “risk premium” of higher long-term interest rates because of uncertainty over its rising debts. 

Some say the UK has been on the naughty step since the gilts crisis that followed Liz Truss’s 2022 “mini” Budget. But others ascribe it to Rachel Reeves’ decision to increase borrowing in last year’s Budget, leaving herself with only a small amount of wriggle room against her fiscal rules.

Loose fiscal policy is also putting upward pressure on demand in the economy and on prices, meaning the BoE’s main rate of 4 per cent is not particularly restrictive, said Andrew Wishart, an economist at Berenberg. A high so-called neutral rate of interest — a theoretical level where the interest rate neither stimulates nor constrains the economy — would leave the BoE with less scope to lower its target rate sharply from current levels.

Rob Wood, UK economist at Pantheon Macroeconomics, also points to the UK’s persistent current account deficit as a vulnerability. The UK is forecast by the IMF to run a current account deficit equal to 3.7 per cent of GDP this year, compared with a surplus in the Eurozone.

“We are reliant on the kindness of strangers, which makes us more vulnerable,” said Wood. “You only need a government mis-step . . . and suddenly you get a big spike in yields.”

In long-dated maturities, unfavourable supply-demand dynamics have exacerbated the issue.

On the demand side, pension funds are reducing their holdings of long-dated gilts as the defined benefit pension scheme industry winds down. 

On the supply side, the Bank of England’s active sales of gilts as part of its programme to shrink its balance sheet are making matters worse, some say. The UK’s Debt Management Office has been urged by investors to go faster in cutting back the share of long-dated debt in annual gilts issuance, to avoid further upward pressure on yields.

Worries over the supply of gilts can be seen in 10-year gilt yields moving above interest rate swaps of the same duration. So-called swap spreads turned negative in Germany last year for the first time, as investors braced for the relaxing of its constitutional “debt brake”, and the same trend has happened in other markets, too. The negative spread in the UK is about 0.3 percentage points, close to its extreme in the April bond rout.

Will the Budget trigger another bout of bond market volatility?

The chancellor’s headroom against her fiscal rules has been reduced, but not entirely eliminated, by recent rises in long-dated yields. However, 10-year gilt moves have been more muted and the pound — which cratered during the 2022 gilts market crisis — has risen this month, lifted by the inflation numbers.

Investors largely expect Reeves to stay within her fiscal rules, and most expect some form of tax rises or spending cuts at the autumn Budget.

“The risk is that the government doesn’t follow through on the fiscal tightening that they have announced,” said Pimco’s Beck-Friis. “We think that is a very small risk.” 

Some investors expect Labour will be forced to break its commitments not to raise core taxes such as income tax, in order to placate the bond market.

The government’s “reluctance to raise the major taxes” risks “pushing the self-destruct button for the long end of the gilt market”, said Craig Inches, head of rates and cash at Royal London Asset Management.

A number of positive scenarios could come to Reeves’ aid, including stronger growth numbers that would improve debt dynamics.

But for the moment the gilt market remains “vulnerable”, said analysts at Pantheon Macroeconomics in a note on Friday, as they pushed up their year-end forecasts for gilt yields.

They spoke of a chance that the risk premium could fall with more political certainty, but also warned of the “acute risk of another sell-off, should the Budget’s details disappoint markets”.

Data visualisation by Ray Douglas, Toby Nangle and Keith Fray