The yields on UK government bonds, commonly known as ‘gilts’, are now consistently the highest among the G7 group of advanced economies. Why is this, and why should the rest of us worry? Yesterday’s No.10 reshuffle has done little to help but there’s a lot more going on.
The numbers alone are disturbing. The cost of new government borrowing for ten years is now around 4.7 per cent in the UK, compared to 4.2 per cent in the US, around 3.5 per cent in France, Italy and Canada, 2.7 per cent in Germany, and just 1.6 per cent in Japan.
This is all the more remarkable because UK public debt is not particularly high by international standards. In fact, the ratio of debt to national income in the UK, at around 100 per cent, is far lower than in Italy, at 135 per cent, or Japan, at 240 per cent. Even tiny Greece, with debt still over 150 per cent, can borrow at 3.3 per cent.
It does not mean that a UK debt crisis is imminent, or even inevitable
There are three main reasons why UK borrowing costs are such an outlier. First, international investors have lost confidence in the UK government’s willingness to take tough decisions to bring borrowing down, especially after the recent failures to curb welfare spending. The prospect of more tax rises is simply reinforcing fears that the UK is stuck in a ‘doom loop’ of sluggish growth and deteriorating public finances.
This credibility gap is a particular problem for the UK compared to many other economies, notably Japan, where the bond market is dominated by domestic investors who are less likely to look elsewhere.
Second, the Bank of England is actively selling government bonds, reversing the previous policy known as ‘Quantitative Easing’ (QE) and it is doing so more aggressively than other central banks. In contrast, it is widely taken for granted that the European Central Bank will do ‘whatever it takes’ to prop up the bond markets of the weaker euro members (including Greece).
Third, there are fears that higher UK inflation will keep official interest rates higher for longer too, while adding to the cost of inflation index-linked borrowing (of which the UK has a relatively large amount). Conversely, yields in the euro area and Japan are anchored by relatively low inflation and official interest rates there.
This does not mean that a UK debt crisis is imminent, or even inevitable. The increase in bond yields only affects the cost of new borrowing, which provides at least some breathing space.
The average time remaining before each conventional gilt has to be refinanced is more than 13 years, with only 16 per cent falling due in the next three years. The average time left on index-linked bonds is even longer, at more than 17 years. The government can also buy time by adjusting the profile of bond issuance to reduce the risk of failed auctions, or by borrowing short-term funds through an existing overdraft facility at the Bank of England.
But this is only partially reassuring. For a start, there is the risk of contagion to other markets. This was plain to see in the wake of the mini-Budget in September 2022, when the sell-off in the gilt market was accompanied by a panic in the mortgage market, prompting mortgage lending to freeze up. The large falls in the prices of gilts also caused immediate problems for some pension funds. Sterling is especially vulnerable too if international investors continue to lose confidence, which again could have an immediate impact on other asset prices, on inflation, and on the real economy.
The timing of the latest jitters is also especially unfortunate. In a few weeks the Office for Budget Responsibility (OBR) will have to crunch the numbers for the Autumn Budget. Crucially, the OBR’s forecasts will be based on whatever the markets are assuming about the path of interest rates and bond yields over the next five years.
These assumptions could eat further into any remaining headroom or, more likely, make the existing shortfall even larger. This would require the Chancellor to announce even larger increases in taxes, again hitting consumer and business confidence hard and having an immediate impact on economic activity. In short, a crisis of confidence in the bond market could trigger ripple effects which quickly swamp the entire economy. Let us hope for some better news soon.
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