Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The UK’s long-term borrowing costs have climbed sharply, fuelled by investor concerns about the Labour government’s Budget, pushing the gap with Germany to the widest in more than a year.
With three weeks to go to Rachel Reeves’ first Budget, bondholders say the UK chancellor will have to walk a “tightrope” if she is to proceed with her borrowing and investment plans without triggering a gilt sell-off.
The spread between UK and German benchmark 10-year bond yields has already risen to 1.94 percentage points, its highest since August 2023, on worries Reeves will increase debt, as well as concerns about persistent inflation, investors say.
“Financial markets won’t afford much room for additional borrowing,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management.
“Rachel Reeves needs to walk a tightrope, otherwise the gilt market will limit her ability to deliver much of Labour’s agenda.”
Amid reports that the chancellor is planning to relax her borrowing rules to fund increased investment in the October 30 Budget, the 10-year gilt yield has climbed from 3.75 per cent in mid-September to 4.2 per cent on Tuesday.
Dowding added that the memory of the 2022 “mini” Budget, when former prime minister Liz Truss’s unfunded borrowing plans sparked panic in the bond market, was still “etched into the psyche” of gilt investors.
Reeves is struggling to find tax increases to fill what she depicts as a £22bn hole in day-to-day government spending.
She has scaled back plans to increase taxes on non-doms, despite a manifesto commitment, and steered away from hitting private equity staff with the top 45p tax rate after Treasury warnings that such measures could be counter-productive.
UK public borrowing has already overshot forecasts this year, partly because of higher-than-expected spending, and some analysts expect the government will have to sell more gilts in the financial year to March 2025 than the current forecast of £278bn.
The chancellor has tried to reassure nervous investors, telling the Financial Times on Friday that she was not in a “race to get money out of the door” and that she would institute “guardrails” to ensure public money was well-spent on sensible investments.
Tomasz Wieladek, chief European economist at asset manager T Rowe Price, said such assurances were important to “give investors certainty about future gilt issuance” if the government changes its borrowing rules.
He added that the risk of greater-than-expected gilt issuance in coming years was an important factor in pushing up the UK’s borrowing costs.
Investors said the widening gap with German bond yields was also due to expectations the European Central Bank will cut interest rates faster than the Bank of England to boost a sluggish Eurozone economy.
The relatively poor gilts performance was “a reflection of both [interest rate] policy expectations and the Budget concerns”, said Emmanouil Karimalis, a strategist at UBS.
However, BoE governor Andrew Bailey said last week that UK rate-setters could be “a bit more aggressive” in lowering borrowing costs if inflation were to keep on falling.
While his comments buoyed short-term government debt, longer-dated gilts — typically more sensitive to government borrowing plans — continued to weaken.
Fiscal rules changes already discussed within the Treasury include reducing the impact of losses incurred on the BoE’s gilt portfolio and removing liabilities associated with investment vehicles such as Labour’s mooted GB Energy.
Reeves said at the Labour party conference she would end the “low investment that feeds decline” — widely seen as a hint that the government could also tweak the debt target to take more account of public sector assets as well as liabilities.
The government’s bid to rethink its fiscal framework won the support of an influential think-tank on Tuesday as the Institute for Public Policy Research recommended it should ditch its rule requiring public debt to fall between years four and five of the forecast.
It said Reeves would gain around £57bn in “headroom” — or capacity to borrow to invest — if she instead used a separate measure called “public sector net worth” that incorporates a much wider array of assets.
The report argues that some of the extra headroom should be held back as a buffer against an uncertain economic outlook.
The Treasury said: “The chancellor has said the Budget will be built on the rock of economic stability, including robust fiscal rules that were set out in the manifesto. These include moving the current budget into balance, so that day-to-day costs are met by revenues, and debt falling as a share of the economy by the fifth year.”
