British government bonds - known as gilts - are having a rough week. On Friday it sat at 5.04%, easing slightly as oil prices slipped.
This marks a significant shift from the low-yield environment of the past decade, when gilt yields often traded below 1%. The return to 5% levels underscores the deep impact of persistent inflation and fiscal worries on the UK's borrowing costs.
Two distinct yet linked factors are behind this movement. One is the new prime minister's spending ambitions. The other is the rising cost of oil, which has the potential to keep inflation sticky in the UK.
And right now investors are struggling to tell the two apart. According to Colin Finlayson, an investment manager at Aegon Asset Management, "It's very difficult to separate what the gilt market is thinking about Andy Burnham and what's happening with the oil price."
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At the same time, renewed conflict between the US and Iran has pushed oil prices sharply higher. Brent crude has jumped about a third in price this month alone. For an energy-importing country like Britain, expensive oil feeds directly into inflation. This pushes the Bank of England to increase its interest rates, which makes existing bonds less attractive.
The result is that the UK now has the highest borrowing costs of any Group-of-10 developed nation. In June alone, the government spent £11.8 billion ($15.7 billion) just to service its debt. "The 5% yield is already raising the government's debt expenditure, and the room for error is very, very limited this time around," said Nicolas Trindade, a senior investment manager at BNP Paribas Asset Management.
The sustained rise in gilt yields has real-world consequences beyond financial markets. Higher government borrowing costs mean that the Treasury has less room to fund public services or cut taxes. Moreover, the Bank of England's expected rate hikes could push up mortgage rates for millions of homeowners, squeezing household budgets. The Autumn Budget, expected in October, will be a crucial test of whether the government can reassure markets without stifling growth.
The next big date on the calendar is the Autumn Budget, when the government is expected to lay out its detailed tax and spending plans. The Bank of England is expected to leave rates unchanged at its next meeting. Some investors are steering clear of UK bonds entirely.
Craig Veysey at Guinness Global Investors says he holds no gilts at all, preferring European government bonds instead. Others, like Ranjiv Mann at Allianz Global Investors, are more optimistic and think the Bank of England will hold off until after the Autumn Budget.
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