Written by Rob Morgan, Chief Investment Analyst at Charles Stanley
A slow but steady rise in the UK’s government’s cost of borrowing has wider implications for investors and for household finances.
UK government borrowing costs have ratcheted up to a 25-year high in recent weeks as gilt yields continued to rise. The yield on 30-year gilts for instance rose above 5.4%, having been as low as 1.5% only three years ago. What’s causing the market turmoil and what does it mean for you?
Why are gilt yields rising?
It’s down to a combination of factors, both domestic and overseas. The Autumn Budget increased expectations around the extent of UK government borrowing, and at the same time weak economic growth implies a greater need to borrow in the future.
There are also nagging concerns that inflation is back on the rise and that interest rates will need to stay relatively high to help rein it in. Fiscal policies unveiled in the Budget, notably the increase to employer national insurance, stands to add to upward pressure on prices and mean services inflation may be hard to flush out of the system owing to its typically higher labour intensity.
It’s not just a domestic issue though. The UK is being buffeted by overseas inflationary forces. There are concerns that should US President-elect Trump look to implement his tariff-led trade approach there could be a significant impact on the costs of business globally. At the same time, the US economy is running hotter than many predicted with possible tax cuts still to come. Consequently, expectations of interest rate reductions from the Federal Reserve (Fed) have fallen back, with the current consensus being only one 0.25% cut this year owing to the perceived likelihood of inflation remaining higher than the Fed’s target.
This more inflationary picture globally has a significant impact on the UK as it is a relatively vulnerable position. Current and fiscal deficits are the second highest among major developed markets, only behind the US. While the dollar benefits from reserve currency status, this is not the case for the UK, making it more sensitive to foreign investor flows. Some have also pointed to more technical factors in the gilt market where there is less regular buying from pension funds and other institutions.
What does it mean for investments?
Gilt funds, especially those concentrating on longer dated maturities, have experienced steep losses since the start of December. Other bond funds will also have been caught up in the wider trend of higher interest rate and inflation expectations, although those dominated by either higher yield or short dated bonds will have been relatively resilient because they are less impacted by shifting inflation and interest rate expectations.
Going forward there are some reasons to be positive on UK gilts. While the growth outlook doesn’t look great, with inflation now nearer to target and financial conditions posing downside risks, the Bank of England may now be able to deliver greater interest rate cuts than anticipated. This stands to ease the pressure on consumers and businesses later this year, potentially improving the growth picture a little, and it may help take the heat out of rising gilt yields.
However, it is also possible that interest rates will have to remain higher than expected. Major retailers have already warned that food prices may resume an upward trajectory, and a recent upward blip in the previously subdued oil price could herald a further inflationary pulse on top of the expected impact of Donald Trump’s reprise as US President.
While the increase in gilt yields is not as extreme as what we saw in 2022 amid concerns over unfunded tax cuts under the Liz Truss administration, we should expect volatility, especially in the short term.
What does it mean for people’s wider finances?
Gilt yields can have an impact on other areas of personal finances, for instance by impacting borrowing costs.
Some mortgage lenders have been hiking their rates in recent weeks, although it is generally shorter-term inflation and interest rates rate expectations that impact the ‘swap rates’ that dictate mortgage pricing, and these have been more anchored than medium- and longer-term expectations. This contrasts with the mini-Budget episode in 2022 where mortgage costs did escalate more significantly.
Meanwhile, one positive aspect is that annuity rates have moved higher as they are largely based on longer term gilt yields. The higher the gilt yield the bigger the potential regular retirement income. If you have been contemplating buying an annuity with your personal pension pot, it might be an opportune time to take a fresh look at available rates.
