Government borrowing costs rise as Rachel Reeves comes under pressure

Government borrowing costs rose sharply on Thursday, partially erasing gains made in recent months, in another blow to Rachel Reeves’ Budget plans.

Gilt yields – the interest paid on Government debt – are under sharp focus ahead of the 26 November Budget as sky-high debt servicing costs erode the Chancellor’s fiscal headroom and her capacity to spend elsewhere.

The impact of higher debt servicing costs could also make it necessary for Reeves to consider more aggressive tax hikes.

Gilts faced selling pressure on Thursday as comments from Federal Reserve chair Jerome Powell overnight weighed on expectations for more interest rate cuts.

Stocks, bond and gold all fell in response to the Fed’s ‘hawkish’ rate cut, with another one in December no longer viewed as a certainty.

Gilts fell across all durations, with five-, 10- and 30-year yields up by 5 basis points each by mid-afternoon in London. Longer duration gilts recovered ground later in the afternoon for yields to trade 3bps to 4bps higher for the day.  

Under pressure: The impact of higher debt servicing costs could make it necessary for Reeves to consider more aggressive tax hikes

The sell-off also came as Reeves came under intense political pressure over revelations she had rented out her family home without a licence.

The latest move in gilt yields will frustrate the Chancellor after a sizeable fall in Government borrowing costs over the last month.

Long-term borrowing costs have been elevated for some time, amid market concerns about UK fiscal strength and the view that higher inflation will result in higher-for-longer interest rates.

Goldman Sachs believes the Bank of England will cut base rate by 25bps to 3.75 per cent next week, following growing evidence of weak economic output.

However, market consensus suggest the BoE will hold off until December or even wait until next year for another cut, amid stubbornly high inflation.

Ten- and 30-year gilt yields have still fallen 25bps and 30bps over the last month, respectively, to 4.4 and 5.2 per cent.

Thomas Pugh, chief economist at RSM UK, said financial markets ‘have gone from pricing in less than a 25 per cent chance of another rate cut by the end of the year to a two-thirds chance now, due to a lower inflation peak and rumours of a less-inflationary budget’.

Pugh thinks the BoE will keep base rate on hold at its current level of 4 per cent next, but said the door is open to a December cut – ‘especially if the budget is deflationary’.

He added: ‘The BoE has been on a pretty consistent once-a-quarter rate cutting path for the last eighteen months or so.

‘However, stubbornly strong wage growth, sticky inflation, the upcoming budget, and a clear shift by the MPC from worrying about the labour market to worrying about inflation meant it seemed likely to diverge from this path and keep rates on hold until at least February – until recently anyway.’

Analysts at ING predict the BoE will cut three more times this cycle, bringing base rate to 3.25 per cent assuming each move is 25bps lower.

They wrote in a note on Thursday: ‘Reeves faces a fiscal shortfall of roughly £25billion/year.

‘That’s likely to be made up through a combination of extending the freeze on tax thresholds, extending national insurance [payroll taxes] to landlords and partnerships, raising bank taxes, as well as tax on dividends/certain types of capital gains.

‘The Treasury is loath to do anything that might add to inflation, even if its scope to lower it is limited. All of that should mean gilt issuance falls next year in line with the Debt Management Office’s projections.’

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