Macroeconomics

UK - More scare than crisis

10 January 2025 • 4 mins read

Britain's Former Prime Minister Liz Truss. AFP.

So far this year 10Y government bond (Gilt) yields have jumped 25bps to 4.83% and by 100bps since September to reach their highest levels since 2008.
First, the new Labour government’s budget lifted borrowing sharply. Second, firm inflation and weak growth data have raised fears of stagflation, and, last, global bond yields have been rising too.
The sell-off in Gilts and the GBP has echoes of former Prime Minister Truss’s disastrous 2022 mini- budget. But the weakness of UK assets may only be temporary rather than the start of a full crisis.
If higher borrowing costs puts the government’s fiscal targets at risk then it is likely to cut spending. That would hurt UK growth but the Bank of England would then respond by cutting interest rates faster.

So far this year 10Y government bond (Gilt) yields have jumped 25bps to 4.83% and by 100bps since September to reach their highest levels since 2008. Similarly, the GBP has fallen from 1.34 to 1.22 against the USD.

Source: Bank of Singapore, Bloomberg

The sell-off in UK assets has three drivers. First, the new Labour government’s budget in October sharply increased borrowing by an average of GBP32.3 billion per year over the next five years, adding more than 1% of GDP to the UK’s already high fiscal deficit as the second chart shows.

Second, the latest UK data shows inflationary pressures remain stubborn. Headline inflation is near the Bank of England’s 2% target at 2.6% but core inflation is still 3.5% and services inflation 5.0%.

Source: Bank of Singapore, Bloomberg

At the same time, recent growth data has been weak. Monthly GDP has only risen once since May. Thus, investors fear the new government’s budget of higher spending and tax rises has hurt confidence, causing the economy to flirt with stagflation.

Third, global bond yields have also been rising. US 10Y Treasury yields have surged more than 100bps since September to 4.70% in anticipation of more inflationary policies during a second Trump term.

The sell-off in Gilts and the GBP has echoes of former Prime Minister Truss’s disastrous mini budget in 2022 when 10Y Gilt yields rocketed within days from 3.00% to 4.60% and the GBP fell to an all-time low of 1.03-1.04 against the USD. As the chart shows, the UK runs ‘twin deficits’ on its fiscal and current accounts so is dependent on maintaining investors’ confidence.

But we think the comparison is false. Instead, the weakness of UK assets may only be temporary rather than the start of a full-blown crisis. In contrast to Truss, Chancellor Reeves seems intent on meeting the UK’s fiscal rules constraining borrowing. If the Office for Budget Responsibility (OBR) Spring forecasts on March 26 show the rules are in breach, the government is set to reduce spending, most likely on investment. That may hurt near-term growth. But the Bank of England would respond by lowering interest rates faster than its current pace of quarterly 25bps cuts. We think fiscal tightening and further monetary easing would be sufficient to restore confidence, letting UK markets rebound from this year’s losses.

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Author:

Mansoor Mohi-uddin

Bank of Singapore