Explainer-Why are UK borrowing costs jumping?

By William Schomberg

LONDON (Vivid Bulletin) - Britain's government borrowing costs have risen sharply this week, adding to the difficulties facing finance minister Rachel Reeves who is planning to sell hundreds of billions of pounds' worth of bonds this year to fund public services and investments designed to promote growth.

What's currently happening in bond markets?

Yields on 30-year British government bonds surged significantly on Tuesday and rose again on Wednesday, surpassing other governments' bond increases and hitting a high of 5.383% since August 1998. The pound also depreciated.

Increasing bond yields indicate that investors are seeking a greater return for their investment, which typically leads to a stronger pound.

Markets are concerned about the high borrowing costs and persistent inflation in Britain, as well as the consequence of President-elect Donald Trump's policies, which are forecast to intensify inflationary pressures in the US. US 30-year bond yields reached their highest level in over a year on Tuesday and increased once again on Wednesday.

Adding to the pressure on UK yields is the Bank of England's concern about cutting interest rates due to inflation being higher than the target.

The moves in gilt yields and sterling have been sharp, but less dramatic than during the 2022 "mini-budget" crisis under former prime minister Liz Truss.

What actions taken by the United Kingdom government?

Prime Minister Keir Starmer - who led the Labour Party back to power in the election last July - and Reeves stated in their first budget on 30 October that they planned to borrow approximately 142 billion pounds more over the subsequent five years than initially intended. The UK already has public debt of 2.8 trillion pounds (£3.5 trillion), equivalent to around 100% of GDP – which is lower than in many other wealthy economies, yet higher than the approximately 35% recorded pre-2007-08 global financial crisis. The COVID lockdowns exacerbated the debt burden. The government's annual debt interest bill has more than doubled as a proportion of gross domestic product since the pandemic. In addition to borrowing more, the new administration has announced employer tax rises, which have impacted hiring and investment plans.

What can Rachel Reeves do about it?

Rishi Sunak has promised to bring public spending and tax revenues into balance by the end of this decade. However, many economists are concerned that the recent hike in borrowing costs and stagnation of the economy since mid-2024 may mean that Britain's fiscal forecasters will say he is no longer on course. In order to get back on track, Sunak might need to raise taxes again or announce spending cuts for the late 2020s, although he may not actually have to implement these measures. Nevertheless, he will need to tread carefully so as not to panic investors who are already concerned about Britain's debt levels. The next official fiscal forecasts are due to be published on 26 March when Sunak will deliver a budget update speech to Parliament.

What are the government's key expenditure constraints?

Reeves and Starmer say that the extra tax revenue and increased borrowing will fund improvements to Britain's public services and also invest more in infrastructure to aid future economic growth. However, they are facing demands to spend even more on services like healthcare and education as well as defence. Raising defence spending to 2.5% of GDP from 2.3% by the end of the decade, as demanded by Trump of his US allies, would be around 6 billion pounds per year, equivalent to the entire current annual budget for education - excluding staffing costs.

What's likely to come about subsequently?

Pension investors are waiting to see whether Trump - who takes office on 20 January - will implement his threat to impose strict customs duties on imports. Although Trump has not explicitly stated that Britain would face such duties, they would lead to higher US inflation and, in turn, increase yields on gilts (which are sensitive to US borrowing costs) and US Treasuries. CNN reported on Wednesday that Trump is contemplating declaring a national economic crisis to pave the way for tariffs. Any significant Trump tax cuts and increased public spending could also fuel inflation in the US. For the UK, the swiftness of interest rate reductions by the Bank of England (BoE) is a critical factor governing gilt yields. Markets have predicted two quarter-point interest rate cuts this year, whereas most economists forecast four. If the economists are correct, gilt yields would fall.

($1 = 0.8035 pounds)

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