UK government borrowing costs jump amid persistent inflation fears

The cost of government borrowing in the UK has surged as concerns about stubborn inflation have led to expectations that interest rates will remain higher for longer.

Government bonds in the UK and US have sold off sharply, as investor appetite for holding this type of debt has fallen, which has sent yields higher.

Economic data releases this week have stoked fears that inflation will remain sticky and prompt central banks to slow down their pace of interest rate cuts.

This has led the pound to slump against the dollar (GBPUSD=X), plunging 1% to $1.2339 on Wednesday afternoon — it’s lowest point since April.

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 effectively refer to the interest rate return that 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.

Meanwhile, Susannah Streeter, head of money and markets at Hargreaves Lansdown (HL.L), said that a closely watched US jobs report due out Friday is expected to be “robust”.

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She said that this would indicate “persistent strength of the US economy. Although such a show of strength might be seen as good news, it’s leading to concerns that the Fed will go even slower on interest rate cuts.”

The Fed has already warned there would likely be only two rate cuts this year, down from the four forecast in September. Streeter 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 4.68% on Wednesday — its highest level in eight months.

The yield on the UK’s 10-year gilts has risen to 4.79%, 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 5.35%.

“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,” said Streeter. “There are concerns this may limit the interest rate reductions this year.”

Given yields are effectively the interest rates on these loans, their rise on gilts and Treasuries means higher borrowing costs for governments, at a time when concerns have been growing about sovereign debt levels.

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.”

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