UK on precipice of economic crisis

Surging gilt yields heap pressure on Chancellor Rachel Reeves, raising the prospect of further tax rises or spending cuts.

10 January 2025

The UK started the New Year by getting dangerously close to an all-out economic crisis. The 10-year gilt yield rose to 4.8%, the highest since 2008, while cable fell to the lowest in over a year at USD 1.23. This puts Rachel Reeves’ efforts to gain the confidence of capital markets at dire risk, not to mention her fiscal plans which assumed a lower level of long-term interest rates.

To be fair, a little bit of this is not of the UK’s making. Firstly, the gilt market bears some correlation to what’s happening in bonds Stateside, and amid the Trumpian narrative of lower taxes and deregulation US Treasury yields have been soaring. The 10-year US Treasury yield now stands just shy of fully 4.7%, driven upwards mostly by not unreasonable moves in real yields, ie growth expectations. This in turn is putting upward pressure on gilt yields in the UK.

Secondly, the US dollar has been strong generally as the US economy has been thriving and the Federal Reserve has indicated that further rate cuts could be slower to arrive this year. This has pulled global capital looking for decent risk-adjusted yield into the US, and that means the greenback has inevitably benefited, to the detriment of most other currencies. But that’s as much of a pass as the UK is going to get. The rest of this slow-motion crisis is of Britain’s own fabrication. Rachel Reeves left very little headroom against her primary fiscal targets, specifically just under £10 billion in the October budget. This has now virtually disappeared because of the higher borrowing costs coming from the rise in long-term interest rates which are set by the gilt market. If the market situation doesn’t improve, there will have to be some kind of awkward between-Budget announcement, raising taxes (economically difficult) or cutting spending (politically difficult).

The irony of course is that Prime Minister Starmer has repeatedly talked of Liz Truss “crashing the economy” but gilt yields are now actually higher than they were in the aftermath of Ms. Truss’s infamous mini-Budget in 2022. That cease-and-desist letter sent by her lawyers to Sir Keir may not be needed after all as the new government scrambles to contain a situation which is beginning to look just as self-inflicted.

2022 Redux

For the more circumspect, none of this will come as a surprise, it is merely another milestone along the long journey of Britain’s secular decline. In 1900, the pound was worth a whopping USD 4.86. Not all UK investors will be feeling down in the dumps though. For those with significant exposure to US equities and whose portfolios are denominated – but not hedged – in sterling, these are golden times indeed.