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The UK’s long-term borrowing costs climbed to their highest level since 1998 on Tuesday, as a deepening of the Hormuz crisis added to fears the economy faces a prolonged period of higher inflation.
Thirty-year gilt yields rose as much as 0.14 percentage points to 5.79 per cent, their highest level in almost three decades, before dipping slightly to 5.74 per cent.
The yield on the 10-year gilt climbed as much as 0.15 percentage points to 5.11 per cent, close to the 18-year high of 5.12 per cent hit earlier in the Iran war. It was later at 5.06 per cent. Yields rise as prices fall.
Gilts have sold off during the conflict as traders bet the Bank of England will be forced to lift borrowing costs to tackle the inflationary fallout from soaring oil prices, in an economic squeeze that is piling pressure on UK Prime Minister Sir Keir Starmer ahead of devolved and local elections on Thursday.
Britain’s rising borrowing costs, already the highest among the G7, are an increasing strain on the public finances of a country whose debt interest costs exceed £100bn a year.
“There is just no sign of this war ending anytime soon,” said Pooja Kumra, rates strategist at TD Securities. “Gilts certainly get hit not just on inflation worries, but also brewing political risks ahead of local elections.”
The rise in market interest rates since the fiscal statement in March could reduce the headroom of chancellor Rachel Reeves from £23.6bn to about £18.5bn, according to Ruth Gregory at Capital Economics. But she added: “That’s before considering weaker real GDP growth and higher inflation.”
The Treasury declined to comment on the rise in yields.
Oil prices have been trading well above $100 a barrel in recent days as the Middle East conflict continues, which has fuelled a slow-moving sell-off in global long-term government bonds that took the US 30-year yield to 5 per cent for the first time since September.
Gilts have been the worst-performing major bond market since the conflict started, reflecting the country’s elevated inflation ahead of the war and the economy’s particular vulnerability to rising energy prices.
Aaron Rock, head of rates at asset manager Aberdeen, said the gilt market “seems to want to shoot first and ask questions later” ahead of the elections, adding: “There is definitely an element of that political premium returning to gilts.”
Traders now expect the BoE to deliver two to three quarter-point rate increases by the end of the year to combat resurgent inflation. Before the conflict, traders were betting that the Monetary Policy Committee would lower borrowing costs to boost economic growth.
The spectre of higher inflation comes as rising political risks in the UK also unsettle investors. A heavy defeat for Starmer’s ruling Labour party in local elections in England on Thursday, plus devolved polls in Scotland and Wales, could pave the way for a shift to the left and a loosening in the government’s fiscal rules, which investors have warned against.
The rise in yields comes despite the government’s efforts to mitigate it by issuing less long-term debt. The Treasury on Tuesday said it will start selling 12-month Treasury bills — in addition to the one, three and six-month maturities it already sells — as part of an effort to expand the market for short-term government debt. It also announced other steps to boost liquidity in the bills market, including a new repo facility.
Traders are betting the election outcome will be negative for the pound and have been buying so-called put options on sterling that benefit from weakness in the currency. Put options on the sterling-dollar exchange rate made up 70 per cent of those sold last week, against 30 per cent calls, according to data from derivatives giant CME Group.
UK 30-year yields, which are sensitive to fears of higher inflation and concerns over the scale of government borrowing, have underperformed other countries’ long-dated bonds in recent weeks.
Greater Manchester mayor Andy Burnham — viewed as a possible challenger to Starmer in any leadership election, although he would have to win a parliamentary seat first — said on Wednesday last week that a rise in defence spending could be considered “exceptionally outside of the [UK’s borrowing] rules”. The Treasury has said the fiscal rules are “non-negotiable”.
“The local elections on Thursday are a big risk for bond markets,” said Rob Wood, chief UK economist at Pantheon Macroeconomics. With Labour on track to lose heavily, Starmer might be replaced by a more leftwing leader, pushing up yields, he added.
In the medium term, the perceived chances of a Reform-led government could increase in the wake of the elections. “The markets will not trust that Reform will be a responsible custodian of the public finances,” Wood said.
