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The UK’s borrowing costs jumped on Friday to their highest level since 2008, as fears of an inflation shock intensified and the economic fallout from the war in the Middle East continued to grow.
Ten-year gilt yields, the main benchmark for long-term government borrowing, climbed to 5 per cent, extending a sharp three-week sell-off in bond markets. Two-year gilt yields, which are more closely tied to expectations for Bank of England interest rates, rose by 0.17 percentage points to 4.57 per cent, their highest level in more than a year. Traders are now pricing in three quarter-point rate rises this year, a major reversal from expectations before the conflict, when markets had anticipated lower borrowing costs.
The shift reflects mounting concern that higher oil and gas prices will feed into inflation. Oil was trading near $110 a barrel on Friday, and because the UK is heavily reliant on imported energy, it is seen as especially vulnerable to this kind of shock. Those worries were reinforced earlier this week when the Bank of England signalled it could raise rates further if the energy shock proves prolonged.
Paul Dales, UK economist at Capital Economics, said markets were reacting both to developments in the Middle East and to the worsening outlook for energy prices, as well as the possibility of a stronger policy response from the central bank. With inflation rising and higher borrowing costs squeezing households, he warned that the UK could easily be pushed towards recession.
The market turmoil quickly spilled into the real economy. Mortgage lenders began withdrawing deals, while the average rate on a two-year fixed mortgage climbed to 5.35 per cent on Friday, its highest level in a year, according to Moneyfacts. At the same time, households were warned to expect a sharp increase in energy bills. Cornwall Insight estimated that the energy price cap for July to September would leave the typical annual gas and electricity bill at £1,972, up from £1,641 between April and June.
The pressure on the economy is also creating major political and fiscal problems for chancellor Rachel Reeves. Only this month, she used her Spring Statement to praise the “stability” the government had restored to the public finances. The latest jump in gilt yields and the wider economic consequences of the conflict now threaten to undermine that message.
The rise in borrowing costs makes Reeves’ fiscal position even more difficult. Colleagues reportedly say she is spending virtually all her time focused on the Iran war and considering what support may be needed for households and businesses facing higher energy prices. One Treasury insider described the mood in the department over the past week as “pretty bleak”, saying the conflict risked unravelling much of what she had planned.
Reeves has already ordered an internal Treasury review of the 2022 energy support package, with a view to ensuring that any future help is more tightly targeted at those most in need. She has said any new support would be focused on the most vulnerable, but doing so would still put pressure on her fiscal plans, especially if inflation remains high and interest rates fall more slowly than expected.
The Treasury insists Reeves’ fiscal rules remain non-negotiable, increasing the possibility that she may need to raise taxes again in the autumn Budget to keep the books balanced. Although she doubled the headroom against her main fiscal rule to £22bn in the November Budget, economists warn that margin could quickly disappear if growth weakens and debt interest costs rise when the Office for Budget Responsibility next updates its forecasts.
Those concerns were heightened on Friday by new figures showing the UK borrowed £14.3bn in February, more than expected. That adds to the strain at a time when the government plans to issue £252bn of gilts this year and is already paying more than £100bn a year in interest on its existing debt.
Pooja Kumra, rates strategist at TD Securities, said that when gilts move, they tend to move sharply. She added that the Bank of England’s unexpectedly hawkish turn had caught markets off guard, especially since many had still hoped for delayed rate cuts. Meanwhile, the pound fell 0.8 per cent against the dollar to $1.333, underlining the wider sense of unease in financial markets.
