UK government borrowing costs are rising ahead of rival countries

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The premium for UK government borrowing costs over the US rose to its highest level for almost a year this week as investors bet that a more complicated inflation outlook and a recovering economy would keep UK interest rates steady higher for longer.

The yield on 10-year gilts rose to more than 4% this week, pushing the gap between benchmark UK and US borrowing costs to 0.18 percentage points.

Before Friday’s small pullback, it marked its highest level since last September. By early August, benchmark US Treasury yields were higher than their UK counterparts throughout 2024.

Rising borrowing costs in the UK partly reflect concerns about persistent domestic services inflation and a resilient economy that is keeping interest rates high.

UK government debt prices also lagged their European counterparts this month as investors bet that weaker euro zone inflation data would raise the chances of multiple interest rate cuts by the European Central Bank in this year.

“During the year there was a consensus that the UK would be hit by a recession and gilts became a consensus (buy). . . This year we were proven wrong,” said Shamil Gohil, portfolio manager at Fidelity International.

“Stick services inflation, strong wages and revised GDP all point to solid UK data and a Bank of England easing cycle that will be gradual,” he added.

Traders in the swaps market expect the BoE to cut another one or two quarters of a point this year, compared with two or three for the ECB and one percentage point of cuts by the Federal Reserve.

The strong performance by US Treasuries comes after Fed Chairman Jay Powell told a summit last week that “the time has come” for US interest rate cuts, while BoE Governor Andrew Bailey warned it was “too soon to declare victory over inflation’ in Britain. .

UK services inflation has remained stubbornly high despite recent improvements. It was 5.2% for the year to July, compared with 4.9% in the US. Eurozone services inflation in August was 4.2%.

Economists are also cautious that UK interest rates will remain high while the economy remains resilient. After entering recession last year, it has grown for consecutive quarters. Analysts now estimate that the UK economy will grow by 1.3% in 2025, compared to an estimate of 1.1% earlier this year.

“Stronger growth in the UK. . . could introduce upside risks to inflation, potentially limiting the BoE’s ability to cut interest rates,” said Jason Da Silva, director at Arbuthnot Latham.

Some investors warn that heavy bond supply is also weighing on gilt yields. The government issued £3.1bn of debt in July, far more than the £0.1bn forecast by the Office for Budget Responsibility, the UK’s fiscal watchdog, and the £1.5bn pounds predicted by economists polled by Reuters.

“There was some fiscal slippage in the deficit. . . they’re probably weighing the sprinkles,” said Peder Beck-Friis, an economist at Pimco.

The government may also announce more borrowing in its upcoming budget. “The new Labor government has had a difficult start to its term, highlighting the dire state of the public finances and at the same time making it worse by increasing public sector wages,” said Craig Inches, head of rates and cash at Royal London Asset Management. .

He added that this “could lead to higher borrowing, effectively increasing an already bloated supply of UK gold”.