UK borrowing costs climb as ‘stagflation’ fear stalks gilt market

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Worries over the stagnating UK economy and accelerating inflation are unnerving investors, pushing borrowing costs to their biggest premium over German debt yields since 1990.

The spread between the two countries’ bonds has risen above 2.3 percentage points, the highest since German reunification and eclipsing the peak reached after Liz Truss’s ill-fated “mini” Budget two years ago.

“Stagflation concerns are back for the UK bond market,” said Robert Dishner, senior portfolio manager at Neuberger Berman.

He added that investors were also “a little on edge” over the scale of the Labour government’s plans for borrowing, which could increase further if weak growth held back tax receipts. 

The gilt market moves come ahead of the Bank of England’s final policy meeting of the year on Thursday, with investors betting that persistent inflation will prevent the central bank from cutting its benchmark rate, despite the stagnating economy.

Recent data showed GDP unexpectedly shrank for a second successive month in October.

The rise in gilt yields has also taken government borrowing costs back close to the one-year high struck last month after chancellor Rachel Reeves’ October Budget, which briefly unsettled investors by stepping up the Treasury’s debt issuance plans.

Ten-year gilt yields climbed 0.05 percentage points to 4.57 per cent on Wednesday following figures showing that UK inflation accelerated to 2.6 per cent in November.

“Higher borrowing costs continue to undermine the UK fiscal position,” said Mark Dowding, chief investment officer at RBC Bluebay Asset Management.

“If gilt yields blow above levels seen in the Truss tantrum, Rachel Reeves could end up breaking more promises and being forced to raise taxes or cut spending in order to allay concerns relating to debt sustainability.”

The recent increase in yields from less than 4.2 per cent two weeks ago has come as traders bet the BoE will now make just two quarter-point cuts next year, down from four expected in October.

The data “is calling into question the ability for the Bank of England to cut rates,” said Craig Inches, head of rates and cash at Royal London Asset Management.

The gap in yields with the Eurozone is also largely due to investor expectations that the European Central Bank will lower borrowing costs much faster than the BoE as it grapples with an even sharper slowdown in growth.

In addition, the move up in yields reflects a sell-off in the US Treasury market, where investors have trimmed their expectations of 2025 Federal Reserve rate cuts since Donald Trump’s election victory last month.

Economists have long expected a rebound in UK price pressures towards the end of the year, because of so-called base effects, since energy costs fell a year ago, the point of comparison when calculating annual inflation.

However, BoE policymakers are also concerned by the scale of price increases in the service sector, as well as rapid wage growth. 

Services price growth of 5 per cent in November was higher than the BoE’s own forecast of 4.9 per cent and well above the rate seen as being compatible with the central bank’s 2 per cent inflation target.

Separate figures earlier this week showed that average weekly UK earnings, excluding bonuses, rose faster than expected at 5.2 per cent in the three months to October.

The higher government spending and borrowing in Reeves’ Budget are also likely to add to inflationary pressures. 

Those measures will add 0.75 percentage points to GDP and around 0.5 percentage points to consumer price inflation in about a year’s time, according to the BoE’s latest set of forecasts last month.