Even in a global energy crisis, Britain’s economic struggles stand out. Government borrowing costs have risen to the highest level in three decades, faster than other European and US bond markets.
As the British public heads to the polls in Thursday’s local elections, rising bond yields are an ominous sign for the government, which is bracing for a strong vote result. Bond investors are concerned about the fragility of the country’s political and economic outlook, as debt levels are high and inflation is accelerating.
This week, the yield on 30-year government bonds, known as gilts, rose above 5.7 percent, the highest since 1998. The yield on the benchmark 10-year bond was near 5 percent and has risen almost half a percentage point this year. By comparison, the 10-year U.S. Treasury yield has risen less than 0.2 percentage points. The movement is three times greater than that of German bonds.
“It’s a perfect storm for the UK,” said Katharine Neiss, chief European economist at PGIM Fixed Income.
He cited three mutually reinforcing factors: Britain’s fiscal and economic trajectories, its vulnerability to external energy shocks due to its dependence on imported oil and gas, and its current political uncertainty.
Some of this economic tumult is shared by governments around the world. The effective closure of the Strait of Hormuz has sent energy prices soaring. This is fueling higher inflation and, for many governments, pressure to spend heavily to protect households and businesses, potentially taking on more debt to do so.
Britain, however, starts from a painful point.
At the start of the war in the Middle East, inflation was 3 percent, one percentage point above the central bank’s target of 2 percent. And that’s why interest rates were relatively high to crush persistent inflationary pressures. The government, led by Prime Minister Keir Starmer, was deeply unpopular. It was trying to control social spending and had raised taxes to support investments and public services, while also trying to reduce debt levels. It was a complicated calculation that left Starmer’s opponents, as well as members of his Labor Party, dissatisfied.
That said, there were signs that the economic outlook was improving. Inflation was forecast to fall sharply in April, and the central bank, the Bank of England, said it expected to continue cutting interest rates. Lower rates would have alleviated how much the Treasury was spending on debt interest payments. Another positive indicator: the government borrowed less than expected in the last fiscal year, until March, recent data showed.
But then the war crushed these green shoots. Inflation jumped to 3.3 percent in March and is now expected to accelerate this year. Investors quickly abandoned their expectations that the central bank would cut rates and instead bet on several rate hikes over the rest of the year. Mortgage rates and other borrowing costs rose. The International Monetary Fund cut its forecast for Britain’s economic growth to 0.8 percent this year, from a previous projection of 1.3 percent.
There is now a risk of a “negative spiral,” Neiss said, “where higher inflation means interest rates need to be higher, which means fiscal pressures are tighter.” That leads to more difficult policy decisions on taxes and spending, “which makes the current leadership more vulnerable,” he added.
Some economists, including Neiss, believe investors are exaggerating in their bets on multiple interest rate increases this year. They argue that the labor market has cooled and there is less room for workers to demand higher wages and for companies to aggressively raise prices, minimizing the chances of a devastating rise in inflation. Furthermore, the energy shock could strongly affect demand, which in turn would reduce price pressures. Andrew Bailey, governor of the Bank of England, also said last week that these economic conditions could make workers and businesses cautious.
To date, investors have not shunned British assets. The pound has appreciated against both the US dollar and the euro this year. A sale of 15 billion pounds of 10-year bonds found record investor demand last month. But traders are demanding higher returns on the debt. The sales yield was 4.92 percent, the highest since 2008.
For the government, the higher cost of borrowing is keeping the pressure on as investors watch local election results. There are high expectations (in the betting markets and elsewhere) that Starmer will not finish the year as prime minister. If replaced by a left-Labour lawmaker, investors fear the government could loosen its purse strings and worsen Britain’s debt trajectory.
That could undermine the potential for future interest rate cuts or a recovery in economic growth, Andrew Wishart, an economist at Berenberg, said in a research note. “However, bond markets and electoral considerations will discipline any prime minister.”
