The chancellor is under pressure because financial market moves have pushed up the cost of government borrowing, putting Rachel Reeves’ economic plans in peril.
So what’s going on, and should we be worried?
What is a bond?
UK Treasury bonds, known as gilts because they used to literally have gold edges, are the mechanism by which the state borrows money from investors.
They pay a fixed annual return, known as a coupon, to the lender over a fixed period – five, 10 and 30 years are common durations – and are traded on international markets, which means their value changes even as the return remains fixed.
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That means their true interest rate is measured by the ‘yield’, which is calculated by dividing the annual return by the current price. So when bond prices fall, the yield – the effective interest rate – goes up.
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And for the last three months, markets have been selling off UK bonds, pushing borrowing costs higher. This week the yield on 30-year gilts reached its highest level since 1998 at 5.37%, and 10-year gilts briefly hit a level last seen after the financial crisis, sparking jitters in markets and in Westminster.
Why are investors selling UK bonds?
Bond markets are influenced by many factors but the primary domestic pressure is the prospect of persistent inflation, with interest rates staying high for longer as a consequence.
Higher inflation reduces the purchasing power of the coupon, and higher interest rates make the bond less competitive because investors can now buy bonds paying a higher rate. Both of which apply in the UK.
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Inflation remains higher than the Bank of England‘s 2% target and many large companies are warning of further price rises as tax and wage rises bite in the spring.
As a result, the Bank is now expected to cut rates only twice this year, as opposed to the four reductions priced in by markets as recently as November.
Nor is there much optimism that the economic growth promised by the chancellor will save the day in the short term, with business groups warning investment will be tempered by taxes.
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Is the UK alone?
No. Bond markets are international and in recent months the primary influence has been rising borrowing costs in the US, triggered by Donald Trump’s re-election and the assumption that tariffs and other policies will be inflationary.
The UK is not immune from those forces, and other European nations including Germany and France, facing their own political gyrations, have seen costs rise too. (The US influence could yet increase if strong labour market figures on Friday reinforce the sense that rates will remain high).
But there are specific domestic factors, particularly the prospect of stagflation. The UK is also more reliant on overseas investors than other G7 nations, which means the markets really matter.
Why does it matter to Reeves?
The cost of borrowing affects not just the issuance of new debt but the price of maintaining existing loans, and it matters because these higher costs could erode the “headroom” Ms Reeves left herself in her budget.
Headroom is a measure of how much slack she has against her self-imposed fiscal rule, itself intended to reassure markets that the UK is a stable location for investment, to fund day-to-day spending entirely from tax revenue by 2029-30.
At the budget, she had just £9.9bn of headroom and some analysts estimate market pressure has eroded all but £1bn of that.
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At the end of March the Office for Budget Responsibility will provide an update on the fiscal position and market conditions could change before then, but if they don’t then Ms Reeves may have to rewrite her plans.
The Treasury this week described the fiscal rules as “non-negotiable”, which leaves a choice between raising taxes or, more likely, cutting costs to make the numbers add up.
Why does it matter to the rest of us?
Persistently higher rates could push up consumer debt costs, increasing the burden of mortgages and other loans. Beyond that, the state of the economy matters to all of us.
The underlying challenges – persistent inflation, stagnant growth, worse productivity, ailing public services – are fundamental, and Labour has promised to address them.
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Investment in infrastructure and new industries, spurred by planning and financial market reform, are all promised as medium-term solutions to the structural challenges. But politics, like financial markets, is a short-term business, and Ms Reeves could do with some relief, starting with helpful inflation and growth figures due next week.
