UK 10-year gilt yields have climbed back above 5%, a level that was last reached before the financial crisis in 2008, once again underlining how sensitive Britain remains to inflation, fiscal credibility and political uncertainty.
To be sure, part of the move reflects global forces. Bond yields have risen across many advanced economies. Since the end of February, yields have risen by 49 basis points in the United States and 44 basis points in Germany as investors reassess how quickly central banks will be able to cut interest rates.
Get RSM’s Market Minute economic commentary every morning. Subscribe now.
Sticky inflation, resilient labor markets and concerns about higher government borrowing have all pushed yields higher internationally. But yields in the UK have risen by a whopping 87 basis points to 5.1%.
There are two main reasons for this.
One is the UK’s particular vulnerability to inflation shocks. Britain remains more exposed to swings in energy prices than many other developed economies, while a relatively tight labor market, until recently at least, and structurally weak productivity growth have made domestic inflation more persistent.
Inflation has been above the 2% target for all but a handful of months in the last five years. Wage growth has stayed elevated and services inflation remains uncomfortably high, leading investors to worry that the Bank of England may need to keep interest rates higher for longer than previously expected.
The structure of the UK gilt market also amplifies this sensitivity. A large share of government debt is linked to inflation, meaning higher inflation expectations directly worsen the public finances.
Rising yields therefore become both a symptom and a cause of fiscal pressure: higher borrowing costs increase debt interest spending, which in turn raises concerns about future borrowing requirements.
Politics is adding to the pressure. The betting markets imply an 80% chance that the current prime minister, Keir Starmer, will be replaced by the end of the year. That would mean the seventh prime minister in 10 years.
This lack of political seriousness contributes to a lack of confidence in UK economic policy and manifests as a premium in gilt yields over other countries. Indeed, the memory of the 2022 gilt crisis still lingers.
On top of that, the main challengers to Starmer are generally in favor of more intervention in the economy and greater fiscal expansion.
The prospect of less fiscal discipline and more borrowing if Starmer is replaced, or even if the current government is forced to expand spending to placate the backbenchers, is a key reason why gilt yields have risen by more than twice as much as yields in the U.S. and Germany over the last month.
At the same time, sterling is starting to fall back, despite the prospect of three rate hikes this year. A clear sign that investors are concerned about UK assets.
The big picture is that investors are increasingly questioning whether the UK political system is capable of delivering the spending restraint or tax rises needed to stabilize the public finances over the medium term.
With growth weak, public services under strain and pressure for higher defence and infrastructure spending, markets see a growing tension between political promises and fiscal reality.
Changing prime ministers won’t change the fiscal realities on the ground, meaning any big spending promises are likely to come to a head with the bond market sooner rather than later.
