UK government bonds have been selling off sharply, which has sparked a surge in borrowing costs, sparking concerns that this will put pressure on chancellor Rachel Reeves to further raise taxes and cut spending.
Fears of stubborn inflation have led to expectations that central banks will slow down their pace of interest rate cuts this year, leaving base rates higher for longer.
This has triggered a sell-off in government bonds in the UK and US, as investor appetite for holding this type of debt has fallen.
The sell-off has prompted a surge in the yields on these bonds, which are effectively the interest rate on this debt paid out as a return to investors, meaning the UK government’s cost of borrowing has risen.
The yield on the 10-year UK government bond hit 4.79% on Thursday, which is its highest point since 2008
As a result, the pound has tumbled against the dollar (GBPUSD=X), falling 0.3% to $1.2315 on Thursday afternoon — it’s lowest point since late 2023.
Bonds are a type of investment that represent a loan from an investor to a borrower, with returns made from the interest on paid this debt.
There are many different types of bonds, including government bonds, as well as corporate bonds, which are used by companies to raise funds. Government bonds in the UK are known as gilts and in the US, these types of bonds are known as a Treasury.
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The yields on these bonds are the rate of return an investor can expect to receive each year until it reaches maturity, at which time the borrower is expected to repay the loan.
Yields typically rise as the prices on bonds fall, and vice versa, with this latest sell-off in government bonds driving these interest rates higher.
Markets have been keenly focused on economic data releases, particularly those around inflation, to get a sense of the pace at which central banks will cut interest rates.
Central banks raised interest rates to try to tame rampant inflation and get it back down to a target level of 2%. While rates of inflation around the world have fallen, prompting central banks to start cutting rates last year, they have still stood slightly above this target.
For example, inflation in the UK ticked back up to 2.6% in November, up from 2.3% in the previous month.
The latest reading of the US core personal consumption expenditure (PCE) — the Federal Reserve’s preferred inflation gauge — showed that prices grew by 2.8% in the year to November. While this matched the growth seen in October and was lower than Wall Street’s expectations, it remained above the Federal Reserve’s 2% inflation target.
In addition, the Institute for Supply Management’s (ISM) monthly survey of the US services sector, released on Tuesday, showed prices climbed to the highest level since last January.
These data releases have led to concerns that the Federal Reserve would further slow down its pace of rate cuts this year The Fed has already warned there would likely be only two rate cuts this year, down from the four forecast in September.
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Susannah Streeter, head of money and markets at Hargreaves Lansdown (HL.L), said: “Speculation is brewing that there this could be reduced to just one if price pressures persist.”
As expectations grow of higher for longer rate environment, the yield on the 10-year US Treasury (^TNX) has climbed, rising to an eight-month high of 4.68% on Wednesday. This yield has started to edge lower, though it was still trading at 4.65% on Thursday afternoon.
However, the yield on the UK’s 10-year gilts has continued to rise, climbing above the levels seen in the wake of former prime minister Liz Truss’s mini-budget in September 2022.
And 30-year gilt yields are hovering near their highest point since 1998, trading at 5.36%.
Streeter said: “In the UK, there is also particular concern brewing about stagflation taking hold, given that inflation has been creeping up and pay growth is still hot, while the economy has been stagnating. There are concerns this may limit the interest rate reductions this year.”
The Bank of England (BoE) cut rates twice in 2024 and kept rates on hold at 4.75% at its December meeting. BoE governor Andrew Bailey said that the central bank planned to take a “gradual approach” to future cuts.
Laith Khalaf, head of investment analysis at AJ Bell, said that while Reeves’ maiden budget in October was “marginally inflationary, and did increase overall government borrowing”, US and UK have tracked upwards hand-in-hand since the beginning of that month.
He said the fact that “yields are rising on both sides of the Atlantic does suggest the new year has brought with it a focus on the incoming US president, and the potential for his trade and immigration policies to be inflationary, which has implications for both economies.”
The jump in the cost of borrowing costs for governments come at a time when concerns have been growing about sovereign debt levels.
Indeed, Khalaf said: “Bond investors might also be looking at the giant stacks of government debt already on the books on both sides of the pond and saying thanks, but no thanks.”
In fact, US Treasury secretary Janet Yellen recently warned in a letter to Congress that her agency would need to start taking “extraordinary measures” to prevent the US defaulting on its debt, with it expected to reach its debt limit as early as 14 January.
The level of UK government net debt has hit £2.8tn, which is almost 100% of the country’s gross domestic product (GDP).
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Capital Economics’ deputy chief UK economist Ruth Wilson and UK economist Alex Kerr said in a note on Tuesday that their simplified version of the Office for Budget Responsibility’s model suggested “that the recent rise in borrowing costs has wiped out £8.9bn of the chancellor’s £9.9bn headroom”.
Kallum Pickering, chief economist at Peel Hunt said: “Rising bond yields push up government borrowing costs and pose a problem for chancellor Rachel Reeves’ ability to meet her self-imposed fiscal rules — which include hitting a current budget (excluding public investment) surplus by 2029/30.
“If bond yields rise further, Reeves may be forced to make the economically damaging decision of further increasing taxes or cutting back on planned public spending to balance the books.”
On the one hand, Khalaf said that this current sell-off could “could be a storm in a tea cup which dissipates quickly.”
However, he explained that higher bond yields can “hurt share prices by increasing the cost of company borrowing, thereby depressing profits, and also raising the opportunity cost of holding equities instead of bonds (of if you prefer, the risk-free rate).”
“If higher yields get baked in, equity investors might start to question their exposure, especially in the US where the S&P 500 (^GSPC) sits close to a record high and stock valuations are sufficiently high to leave little room for bad news” he said.
He added that while existing bond investors will be “nursing some modest losses as a result of the latest sell-off.”
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Khalaf explained that the typical gilt fund is down 2.5% over the last three months, which is much lower than the 24% fall recorded in 2022.
“We’re very, very unlikely to see such deeply negative returns given yields are starting from a much higher level, and bonds are also now paying some income, which can offset capital losses,” he said.
“Fresh bond investors might be licking their lips as yields rise and they are able to lock into higher rates,” Khalaf added.
“This is particularly the case for the band of canny short-dated low coupon bond investors, who have been using these bonds as a cash proxy to reduce their tax liabilities. If gilt prices continue to drop, an investment might fall into the red, but investors can still wait for maturity to simply collect the face value of the bond.”
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