“UK long-term borrowings costs highest since 1998” – A BBC headline on 1st September
While developments in global stock markets often grab the headlines, fixed income (bond) markets usually go about their business quietly in the background – and below the public’s radar. So, when news from the bond market moves to the front pages, it’s a signal of something significant and that investors should pay attention. The headline from the BBC above was similarly reported across all the major media outlets.
The cost to the UK government of borrowing long-term is measured by the yield on the 30-year Gilt – a financial loan issued and backed by the government. In the bond market, yields move in the opposite direction to prices. So for this instrument – as yields have soared to a recent peak of 5.85% – the market price has fallen materially. As the cost of servicing the debt rises, it squeezes the budget available for all other areas of spending.
A global issue
The first thing to say about the soaring long-term borrowing cost, is that it is not a uniquely UK problem. We see the same pattern in long-term government borrowing costs across the developed world: Japan’s key 10-year bond yield is at a 30-year high, the US 30-year Treasury is at a 20-year high, the French 30-year OAT is at its highest since 2008, and the German 10-year Bund is at its highest since 2011. Clearly, there are some common concerns.
Inflation
Foremost amongst these is inflation. Bonds hate inflation because it erodes the real value of their fixed cash flows. If you receive a 3% fixed payment, but inflation is 5%, the real rate of return is -2%. Long thought dead, inflation surged post-Covid as a V-shaped recovery in demand met still-depressed supply. It has settled back down since, but remains stubbornly above target across developed economies – for now, 65 months in the US.
The oil price
The principal culprit for inflation ticking up this year is the increase in the oil price following the start of the US-Iran war and the retaliatory strategy quickly adopted by the Iranians of blockading the Strait of Hormuz, through which 20-25% of the world’s oil supply normally flows. From $60 per barrel at the start of the year, the price peaked at $126, fell through April and May before rising again recently, as the cease-fire collapses, to $100.
Fiscal deficits
A second major driver of surging borrowing costs concerns ever expanding fiscal deficits – where government spending exceeds income. News in August revealing that total US debt had risen above $40 trillion – a psychological tipping point; interest costs on this c.20% of total federal spending and larger than the defence budget – as it is in the UK, France and Italy. Higher government debt supply requires higher yields to attract sufficient demand.
‘Hyperscaler’ debt
Adding to the surging supply of government debt is a vast new source coming from the ‘hyperscalers’, with the mega US tech firms investing vast sums to build out AI data-centres. Previously, Capex had been funded out of cash. But as the total rises to a colossal $1trillion next year, it has flipped to being funded by debt. Governments are now having to compete with some of the world’s biggest companies to attract investors.
Warsh more hawkish
The trigger for the most recent uptick in yields is the view that Fed Governor Kevin Warsh’s debut address at the Jackson Hole policy forum marked a more hawkish (pro rate rise) shift – noting “work to do” if inflation did not quickly return to target. With the decision whether or not to increase rates on a knife-edge, Warsh and the Fed are at risk of being “damned if they do and damned if they don’t”, with yields ticking higher regardless.
Why are UK borrowing costs the highest
As by far the largest debt market, what happens in the US impacts everywhere – hence why the drivers behind rising borrowing costs are mostly global in nature. Why though are UK borrowing costs the highest among the G7 economies? Firstly, because the UK is seen to have more entrenched ‘sticky’ inflation. Secondly, our exile to the naughty step – guilty until proven otherwise – ever since the Truss/Kwarteng ‘mini’ Budget fiasco in 2022. Thirdly, because UK pension funds – traditionally the big holders of domestic debt – have drastically reduced their holdings, making us reliant on foreign investors and more sensitive to political, fiscal and currency volatility.
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This article is for general information purposes only and does not constitute financial advice or a personal recommendation. Past performance is not a reliable indicator of future results. Investments can rise or fall in value, and you may receive less than you originally invested. Tax treatment depends on individual circumstances and may change in the future.
