Understanding the Current State of Gilts: What Should Rachel Reeves Consider?

Gilts refer to UK government bonds, named for the gold edges once present on their certificates. These financial instruments are issued by the government through the Debt Management Office to finance government borrowing needs. Currently, there is a significant issue with rising market interest rates, specifically affecting long-dated gilts.

As gilt yields increase, the government’s ultimate cost in debt interest also rises. Estimates suggest that this year, the government could spend around £111 billion on interest payments—far exceeding the budgets of most government departments.

The yields on gilts are crucial for the Office for Budget Responsibility (OBR) when evaluating whether Rachel Reeves will adhere to her fiscal guidelines. An increase in gilt yields may necessitate spending reductions or tax hikes from the chancellor.

What Are the Current Interest Rates?

As of Friday, the yield on ten-year gilts stands at 4.65 percent, nearing levels not seen since early 2008. The yield on 30-year gilts has reached 5.38 percent, close to its peak since 1998.

Reasons Behind the Recent Rise in Gilt Yields

Globally, bond markets have reacted negatively to Donald Trump’s proposed substantial budget that is expected to inflate US government debt. This budget has faced criticism from various quarters, including notable figures like Elon Musk. Additionally, Moody’s recent downgrade of US government debt has further eroded market confidence.

The uncertainties surrounding the US president’s fluctuating tariff policies are also thought to complicate the Federal Reserve’s potential to lower interest rates.

Are US Government Bond Yields Higher Than Those in the UK?

No, the UK’s ten-year gilt yields currently surpass those of the US among advanced economies. US ten-year Treasury yields remain at 4.42 percent, which indicates a more favorable position despite ongoing challenges.

In comparison, other G7 nations have even lower yields, including Italy at 3.52 percent, Canada at 3.22 percent, France at 3.19 percent, Germany at 2.53 percent, and Japan at 1.48 percent. Even Greece, with a ten-year bond yield of 3.26 percent, can borrow at a lower rate than the UK.

Why Are UK Borrowing Costs Elevated Compared to Other Nations?

This scenario has evolved over the past three years; previously, gilt yields were on par with the G7 average. However, the market’s reaction to “Trussonomics,” which stemmed from the controversial mini-budget delivered in September 2022 by then-Prime Minister Liz Truss and Chancellor Kwasi Kwarteng, shifted perceptions. Although Truss’s tenure was short-lived, the lingering effects referred to as the “moron premium” have kept UK borrowing costs inflated.

Underlying Causes of High Borrowing Costs

In addition to elevated government borrowing levels, the UK shares a balance of payments deficit with the US, often referred to as “twin deficits.” Economist Sanjay Rana from Deutsche Bank notes, “The UK’s twin-deficit situation resembles that of the US, but unlike the US, we lack robust growth. Achieving a period of strong, sustainable economic growth could help alleviate gilt issues stemming from the aftermath of the mini-budget crisis.”

Is Inflation a Contributing Factor?

Absolutely. The financial markets harbor doubts regarding the Bank of England’s capacity to reduce inflation to its target of 2 percent and maintain it. Currently, inflation stands at 3.5 percent, while average wage increases of 5.5 percent are inconsistent with achieving this target. Despite the Bank lowering interest rates from a peak of 5.25 percent on four occasions, these reductions have not translated into lower long-term gilt yields.

Rana commented, “Investors have long viewed the UK as a problematic case in terms of meeting its inflation targets.”

Who Holds Gilts, and Could This Be Related to High Costs?

Yes, ownership of gilts has become increasingly concentrated among hedge funds, which are generally less reliable as long-term investors, according to the International Monetary Fund in its latest report on the UK economy.

Economist Philip Shaw from Investec notes, “The shift in ownership trends is tied to the decline of defined-benefit pensions, which has decreased demand for longer-term gilts and shrunk funding gaps in legacy schemes.” Historically, during the 1990s and 2000s, a negative spread between ten-year and 30-year gilt yields persisted, attributed to strong demand from pension funds and a low debt-to-GDP ratio, resulting in a relative scarcity of long-dated gilts. The landscape has significantly changed since then!

What Measures Are Being Implemented to Address These Issues?

The Debt Management Office, which oversees gilt issuance, is currently adjusting its strategy by focusing on shorter maturities—less issuance of long gilts—in an effort to balance supply and demand and lower yields. Concurrently, the Bank is engaged in quantitative tightening (QT), which involves selling gilts to reverse prior quantitative easing. Recently, the Bank canceled a scheduled auction of long-dated gilts, opting instead for the sale of shorter-dated bonds. Thus far, these strategies have yielded limited changes.