Investors priced in the rising inflation risk and the growing likelihood of future interest rate hikes, which led to a surge in borrowing costs for British government.
The yield on the benchmark UK gilt 10-year rose to 4,927%, the highest since July 2008. The two-year yield increased 11 basis points to reach 4.522%, its highest level since January 2020.
Bond yields are inversely related to prices and the sharp increase reflects a large sell-off of government debt.
The UK government has suffered a setback due to the surge in borrowing costs. This has reduced fiscal headroom, and made it more difficult to adhere to budgetary rules.
Inflation concerns are fueled by the energy shock
The ongoing Middle East conflict has disrupted the energy supply and driven up oil prices.
The UK, which is heavily dependent on imported energy, is concerned about the blockade of the Strait of Hormuz.
Edward Allenby, an economist at Oxford Economics, said that energy costs could cause inflation to reach 4% by the end of this year.
He warned that rising costs would reduce the spending power of households and weigh down on economic growth.
Oxford Economics now projects that the UK GDP will grow by only 0.4% this year, and 1% in next year. This is significantly lower than previous projections.
Market bets on more rate hikes
Investors are increasingly betting on the Bank of England raising interest rates multiple time this year despite recent attempts from Governor Andrew Bailey to temper their expectations.
Kathleen Brooks, director of research at XTB, stated that the UK bond market is facing renewed pressure.
“The bond vigilantes have returned to the UK,” she said. She cited a combination of global and local factors.
Brooks pointed out that the UK’s energy pricing structure may amplify rising costs.
“The UK looks like an outlier and multiple factors are the cause of this. The events in the Middle East, as well as the unprecedented repricing by UK interest rate expectations are major factors. Even after Andrew Bailey tried to calm the markets [yesterday], more than three rate hikes this year are expected from the BOE,” she said.
“Our blunt energy price mechanism will cause bills this year to soar, and we have an Labour government that spends more on welfare than it brings in through taxes,” she said. She added that both factors unnerved investors.
UK bond market is outlier
Even before the latest move the UK had some the highest borrowing costs of G7 nations.
The yields on longer-dated gilts (20- and 30-year) have remained above 5%, reflecting investor concerns over inflation and fiscal risk.
Lale Akoner is a global market analyst for eToro. She said that the UK’s vulnerability was highlighted by the recent sell-off.
He said that the move was most aggressive in the beginning, reflecting uncertainty about policy. But longer-dated yields have also risen as investors demand higher compensation for inflation and fiscal risks.
“The UK remains especially exposed due to its sensitivity to the energy prices, and its already stretched public finances which adds upward pressure on borrowing rates.”
Bank of England faces a policy dilemma
The rise in yields highlights the difficult situation facing policymakers.
While inflation risks are high, the economy is slow, which limits the scope for aggressive tightening.
“The Bank of England finds itself in a very difficult position. The growth rate is weak and the demand is soft, which limits the scope for aggressive tightening. However, persistent inflation risks reduce flexibility. This tension is driving volatility along the curve,” Akoner stated.
He said that the current financial market environment could pose greater challenges.
He said that higher yields due to inflation, rather than stronger economic activity, tends to weigh on stocks, pressure valuations and challenge traditional diversification.
The UK bond market will likely remain volatile as investors continue to reassess policy and inflation risks. Borrowing costs are sensitive to both global and domestic fiscal dynamics.
This post explains: Why UK gilt rates are at 2008 levels, and what that means for the economy. It may be modified based on updates.
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