State borrowing costs struck their highest level for almost 17 years on Wednesday amid a continued sell-off in the bond market and investor concerns over the threat of stagflation.
The rise in the cost of servicing government debts could cut into Labour’s expected financial headroom in a potentially worrying sign of how investors see fiscal sustainability in the UK.
This also contributed to a slump in the value of the pound, which dropped to its lowest level since April last year.
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Sterling dropped by as much as 1.1% to 1.233 against the dollar on Wednesday.
The yield on the benchmark 10-year UK gilt, which reflects the cost of government borrowing, climbed by roughly 12 basis points to a peak of 4.81%.
It was the highest reading since the 2008 financial crisis.
The rise in gilt yields has an inverse effect on the price of these government bonds, which fell as a result on Wednesday.
The cost of longer-term borrowing also continued to rise, with the yield of 30-year gilts at their highest level since 1998.
They were up around 10 basis points to a peak of 5.36%.
Globally, there has been a wider sell-off in government bonds in recent months in the face of worries that US president-elect Donald Trump could introduce a tariff policy which would be inflationary for many international economies.
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US Treasury yields also moved firmly higher on Wednesday, with the 10-year yield rising to 4.69% – its highest since April last year.
It came after reports of resilience in the US economy cast doubts over expectations for further cuts to interest rates.
In the UK, the rise in yields came as the Debt Management Office (DMO) sold £4.25 billion of notes on Wednesday, having sold £2.25bn a day earlier.
Last year, the DMO said it expected to sell about £296.9bn of notes over the 2024-25 fiscal year.
The rise in government borrowing costs poses a challenge for Chancellor Rachel Reeves, putting pressure on the Treasury’s ability to increase public spending amid the prospect of higher interest costs.
After the Autumn Budget, Reeves was left with only £9.9bn of headroom to meet her revised fiscal rules. This came despite a £40bn package of tax increases to fuel higher spending.
Higher debt interest costs may mean the Chancellor would need to trim spending plans or bring in more revenue than expected to meet the fiscal rules.
Kallum Pickering, chief economist at brokerage Peel Hunt, said: “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.”
The Chancellor committed last year to having only one fiscal tax-changing event a year.
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On Wednesday, the Prime Minister’s official spokesman said: “I’m obviously not going to get ahead … it’s up to the OBR [Office for Budget Responsibility] to make their forecasts and they’ll make their forecasts at the spring statement in the usual way.
“But I would say when the Government came into office we made very clear why it’s so important to manage the public finances to deal with the £22bn black hole that was in the public finances, because having stability in the public finances is precursor to having economic stability and economic growth.”
Michiel Tukker, senior European rates strategist at ING, said it may take some time for borrowing costs to swing back lower.
He said: “Myriad factors contributed to the stretch higher, including Labour’s spending ambitions, sticky inflation, higher US rates and supply pressures.
“We still see gilt yields settling lower later in the year, but as long as these factors linger, a change in direction may take some time.”