UK markets were plunged into chaos for the third day in a row on Friday after gilts rose to their highest levels since the 2008 financial crisis. Commentators have compared the turmoil to the short-lived Truss premiership, whose mini-budget was blamed for an economic meltdown and resulted in her setting the record for shortest-serving British PM. The pound fell to its lowest against the dollar since November 2023, as investors’ worries about Britain’s ability to pay off its debt have sparked fears of fresh public sector cuts to help balance the books.

Critics have blamed Chancellor Rachel Reeve’s Autumn budget, which businesses said would dent growth and shed jobs from the economy. However, others point out that government bonds are rising across the world, including in Japan, France and Germany. So, is Britain facing a financial crisis of its own making, or is the market simply being swept along by a global current?

Inflation is expected to remain higher for longer

Expectations that the Bank of England would make as many as four interest rates this year were dashed by the latest inflation data which revealed it reached an eight-month high of 2.6 per cent in November. Analysts think a single rate cut in 2025 will now be the likely result, with the pound falling as a result of worries over stubborn inflation.

Gerard Lyons, chief economic strategist at Netwealth told the FT that gilt yields were being driven up by price rises and what he characterised as the ‘poor state of government finances.’ On Thursday the outlet reported fears were growing over the UK’s ability to repay its burgeoning debt:

“The UK is budgeting to run large deficits in the coming years, those deficits will be founded by issuing new gilts which impacts the level of demand for gilts already on the market.

“Similarly, if more investors are selling than buying the gilts already on the market, that pushes the price of those gilts downwards and so the yields go up…

“As the UK economy recorded zero growth in the third quarter of 2024, it is not generating the additional revenue to pay the higher interest bill on new gilts.”

Government scrambles to soothe markets

The British government was reportedly ‘scrambling’ to calm tumultuous markets on Thursday after rising gilt yields were threatening to wipe out the Chancellor’s fiscal headroom and even threatened the prospect of sweeping public sector cuts. Research Director at XTB, Karen Brooks, said the UK economy looked to be in a ‘perilous’ position. Speaking to the Daily Mail she said:

“The UK’s fiscal position continues to look perilous. The Chancellor is expected to make a speech in the coming days, where she may focus on public sector spending cuts rather than further tax increases to meet her fiscal rules.

“However, the rhetoric from the Labour government is one reason we are in this mess in the first place, and there are no guarantees that Reeves will be able to calm the market.”

The UK government has set out strict fiscal rules by which it must abide. Last week a Treasury spokesperson insisted they were “non-negotiable”, meaning that unless borrowing costs come down, fresh spending cuts become likely – or the government reneges on its self-imposed constraints.

Are pensions being hit by gilt yields?

Some pension funds have been told to find more cash to bolster their hedging positions in response to rising borrowing costs – but experts insist pension schemes are not facing an LDI crisis. On Friday Reuters reported that Blackrock told clients that higher borrowing costs had reduced schemes’ collateral resilience – but that they were in a good position to weather the volatility. Speaking to the outlet Carl Hitchman at Callagher Benefit Services UK said:

“If yields did spike materially, then you could see things being stress-tested again. But we’re certain the industry is in a much better place,”

Some experts say pensions are now far more resilient than during the comparable Liz Truss mini-budget fiasco, and that they have been insulated by a more gradual rise in borrowing costs compared to 2022. Pension expert Simon Cohen, speaking to industry outlet Professional Pensions, explained why:

“This is not a Truss crisis as the LDI funds are less leveraged these days and the increase in yields has been more gradual.”

That view was echoed by TwentyFour Management partner Gordon Shannon who told Pension Professional:

“Given the work pension schemes have undertaken behind the scenes since Liz Truss’s Mini Budget disaster, we’re far from another LDI crisis in my view, even if this move continues.”

Top economist says gilt rise not a financial crisis.

Top analysts have sought to bring calm this week, with one insisting rising gilts were a ‘problem, not a crisis.’ Paul Dales at Capital Economics said the current situation was ‘nothing like’ the Truss mini-budget fiasco and said the UK was hit hardest as a result of being the most exposed to global headwinds, commenting:

“The UK has been hit harder than others mainly because of its reliance on overseas investors to fund its current account and government budget deficits. Indeed, the UK’s ‘twin deficits’ are bigger than every other G7 economy, and the euro-zone, except the US, which is seen as a safe haven as the dollar is the world’s reserve currency.

“So, when global risk sentiment declines, the UK is more vulnerable to funds flowing to safer shores.”

However, as MoneyWeek reported, although Capital Economics may not consider the gilt situation to be in crisis territory, they do consider it could force the Chancellor to break her fiscal rules in response to soaring borrowing costs.

High borrowing costs a reflection on the British economy

Many analysts agree that the rising cost of British government debt is being driven by pessimism over its tepid economic activity. One Deutsche Bank analyst said:

“ [T]he combination of sluggish growth and above-target inflation are adding to investors’ nerves, and the current pattern of market moves (with yields up and sterling down) is reminiscent of previous episodes of turmoil.

“So that’s drawn parallels to periods like the 2022 LDI crisis when Liz Truss was PM, along with the sterling crisis of 1976 that culminated in an IMF bailout.

 “Nevertheless, the size of the moves are nowhere near the scale of what happened in 2022, when the 10yr gilt yield moved up by more than 100bps in the three sessions after the mini-budget took place.”

Meanwhile, economists at Goldman Sachs now expect higher borrowing costs to compound the dismal economic picture, acting as a drag anchor on potential growth. The Telegraph reported Goldman Sachs analyst James Mobery now forecasts an additional 0.1 per cent of growth drag which he blamed on “Concerns around the UK fiscal outlook.”

Why are debt costs spiralling?

While the United Kingdom is in the midst of some financial turbulence, it is not, at least yet, being considered as a full-blown financial crisis. The recent surge in gilt yields, reaching levels unseen since the late 1990s and the pound’s depreciation against the dollar have undeniably strained the nation’s fiscal landscape.

Several factors contribute to this volatility. Globally, bond markets are reacting to inflationary pressures and geopolitical uncertainties, notably the aggressive tariff policies anticipated by the incoming U.S. administration. These international dynamics have led to a broad sell-off in bonds, affecting multiple economies, including the UK.

Analysts say the UK’s economic vulnerabilities are accentuated by its substantial twin deficits—both budget and balance of payments deficits—which heighten reliance on foreign investment. The recent rise in gilt yields has escalated government borrowing costs, effectively eroding the Chancellor’s fiscal headroom and prompting discussions about potential spending cuts or tax hikes to adhere to fiscal rules.

Despite these challenges, experts say the current situation differs from past financial crises. The financial system has implemented more robust regulatory frameworks and governance processes, enhancing resilience against market volatility. Additionally, the gradual rise in yields, as opposed to abrupt spikes, allows for more measured responses from policymakers and investors.

In summary, while the UK’s financial environment is undoubtedly under strain due to a confluence of global and domestic factors, the situation remains manageable. Proactive policy measures, strategic international engagements, and a steadfast commitment to fiscal discipline are crucial in navigating this period of economic uncertainty. Continuous monitoring and adaptive strategies will be essential to mitigate risks and foster economic stability in the months ahead.