Andy Burnham will be ‘in hock’ to the bond markets whether he likes it or not
With the highest gilt yields in the G7, more borrowing is no longer an option for the next Prime Minister. That leaves the traditional options: raise taxes, cut spending or embark on more ambitious supply-side reforms in areas such as planning, says Daniel Mahoney
Governments needing money usually have three options: tax more, spend less, or borrow. The cost of government debt is dictated by gilt yields – the interest the government pays – which then affects how much can be borrowed. While events in the Middle East have made financial headlines, even before the conflict Britain had the highest borrowing costs of any G7 economy. Indeed, borrowing more may no longer be an option. So how did we get here? And what can the government do?
The UK has run a deficit every year this century, issuing debt to plug the gap – not abnormal for developed economies. But the cost of servicing that debt pile is. The interest accounts for nine pe rcent of government spending – the fourth largest liability behind welfare, healthcare, and education. Many factors influence gilt yields, but inflation expectations are a key driver for longer-term gilts. Since they pay fixed returns, investors demand higher yields to compensate for anticipated inflation over the bond’s lifespan. Thus, as the Iran conflict raised oil prices, driving inflation, yields ended up surging.
But Britain had already gone from “middle of the pack” on bond yields in 2020 to the highest in the G7. This happened in four stages. First, the now-infamous 2022 “mini-Budget”, when enormous unfunded fiscal loosening was proposed at a time of high inflation and rising global interest rates. Investors lost confidence in the UK’s ability to repay , demanding higher returns to compensate for the risk. Then, in 2024, UK and US bonds started to pull away from some major European countries. There were many reasons – one being that the European Central Bank started cutting interest rates more aggressively than the Bank of England. The UK was seeing higher, stickier, inflation – partly since service-oriented economies are more exposed to pay inflation. But even then UK gilts were still broadly tracking US Treasuries. In 2025, however, they started to rise further as markets assumed higher UK inflation and fiscal sustainability risk. Finally, as the Iran war took effect, gilt markets became especially volatile. Now they are a clear outlier: 10-year gilt yields remain over 30bps higher than US Treasuries, and much higher than all major Eurozone economies.
Geopolitical risk is the main game in town
We may soon see good news from the Middle East. This is highly welcome, since geopolitical risk is the main game in town, but far from a solution. As a major energy importer and an internationally-open economy, Britain is highly vulnerable to world events but domestic risk also figures large. One fear for markets is uncertainty, and the prospect of a change in Downing Street will be reflected in the price of borrowing. We already saw outsized gilts movements at points following the local elections, as investors weighed up the possibility of a leadership challenge. We have also seen the markets react badly to any suggestion of a change to a less market-friendly Chancellor. Whatever happens in Makerfield is likely to trigger a leadership contest – either from Andy Burnham, should he win, or from Labour colleagues blaming Sir Keir for yet another loss. Either way, yields will likely rise, making borrowing more costly.
Which means “more borrowing” is no longer an option. As things stand, there is some light at the end of the tunnel. Over the longer term – as long as there’s a gradual re-opening of the Strait of Hormuz – the spread between UK gilts and other G7 countries’ sovereign debt markets should narrow; political risk looks likely to rise up the agenda in the Eurozone. Even so, gilt yields will probably remain high: Britain remains exposed to other geopolitical risk, short-term domestic risk will continue to be priced in, and there is no obvious solution to our over-reliance on overseas investors.
This leaves the Government with other traditional options: raise taxes, cut spending or embark on more ambitious supply-side reforms in areas such as planning. We have seen, over the course of this parliament, that none of these are politically palatable. Even Sir Keir’s main challenger has already committed to continuing to follow the fiscal rules. The message for any future Chancellor is clear: fiscal responsibility is not a nice-to-have, it is a must. And there is one absolute certainty: we will not be able to ignore the bond markets.
Daniel Mahoney is senior economist at Hendelsbanken