Fears of a long recession and the prospect of higher public spending to tackle the cost-of-living crisis sent interest rates on Britain’s debt to their biggest monthly rise in almost 40 years.
The yield on 10-year UK government bonds, a proxy for the effective interest rate on public borrowing, was on course for its biggest monthly rise on Wednesday since September 1986 after rising to 2.78%.
Putting pressure on the prime minister-to-be to address the Treasury’s deteriorating financial outlook, some analysts predicted the yield would rise before the end of the year to at least 3%.
It comes after Rishi Sunak said there were growing risks that financial markets would lose faith in the British economy amid rising inflation and high levels of government debt, in an attack on the tax and spending plans of his Conservative rival Liz Truss.
About a third of the UK’s total loans have an interest rate linked to inflation, making them more expensive to finance in a period of rising prices.
Trots, the front-runner in the race to succeed Boris Johnson, has been criticized by opposition parties for proposing £50bn of tax cuts that would boost incomes for rich and poor households and profitable companies next year.
Sunak said he is “struggling to see” how the massive tax cuts to support families with the cost of living crisis “stack up”. Using an interview in the Financial Times, he warned that it would be “complacent and irresponsible” to ignore the risk of a loss of confidence in Britain’s financial markets.
“We have more inflation-linked debt than any other G-7 economy – more than double overall,” he said.
The pressure on the government’s borrowing position comes as European and US bond yields also rise, with 10-year US Treasuries now at 3.11%.
However, while this increase in Washington’s borrowing costs failed to dent confidence in the longer-term outlook for the world’s largest economy, keeping the dollar close to record highs, the pound fell sharply to levels seen after the vote for Brexit six years ago.
Sterling fell 5% against the dollar to $1.20 and 3% against the euro this month in response to clear signs that Britain’s economy will suffer more than its rival industrialized nations, dealing with rising gas and electricity prices and weakening activity in the private sector.
The prospect of higher borrowing costs when Bank of England policymakers meet to set interest rates in September, even as the economy enters a prolonged recession, also contributed to sterling’s worst month against the dollar since late 2016 and the worst against the dollar and the euro since mid-2021.
Speeches by central bankers at the annual conference in Jackson Hole in the US last week raised concerns among investors in financial markets that interest rates will need to rise further to quell inflationary pressures, despite forecasts of a recession in most advanced economies.
Azad Zangana, senior European economist at investment manager Schroders, said: “There has been a definitive regime change that is taking us into a new era. More experienced investors may see this as a return to more normal times, similar to the period before the global financial crisis of 2008.
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“However, that remains to be seen. It is possible that the stagflation – a period of sustained high inflation combined with high unemployment and stagnant demand – experienced in the late 1970s and early 1980s is a more appropriate comparison.”
Financial markets estimate a 40 percent chance the bank will raise interest rates by 0.75 percentage points to 2.5 percent next month, which would be its biggest single increase in borrowing costs since 1989. Investors expect rates to reach 4.25% by the middle of next year.
British consumer price inflation hit 10.1% for the first time in 40 years in July, and the Bank predicts it will top 13% in October, when regulated household energy prices are due to rise by 80%.
Goldman Sachs predicted on Monday that British inflation could hit 22% early next year if natural gas prices hold close to current levels. The bank and many other forecasters expect higher inflation to push the UK economy into a prolonged recession later this year.
An Office for National Statistics assessment of the impact on inflation of government energy bill rebates for households found that they could not be seen as lowering inflation.
Analysts at Bloomberg estimated that a deflationary ruling would save the UK government up to £14bn in the cost of funding index-linked government bonds.
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