Government borrowing costs set for worst month since Liz Truss
The government’s short-term borrowing costs were on course to have their worst month since Liz Truss’s ignominious mini-Budget, until the news of United States’ talks with Iran led traders to unwind bets future interest rate hikes.
The two-year gilt yield jumped by eight basis points on Monday morning, meaning the interest rate on the government’s short-term borrowing had reached more than 110 basis points – or a full 1.1 per cent – higher than before the onset of hostilities in the Middle East.
Longer-dated securities were also swept up in the sell-off, with the 10-year gilt yield – the benchmark for a government’s capacity to borrow – the highest it had been since the global financial crisis.
But later on Monday, Donald Trump revealed the US had committed to a five-day pause on its unrelenting series of air strikes, while diplomatic talks got under way. The negotiations, which were denied by Iranian officials, were the first real sign of easing tensions since the onset of hostilities last month.
UK bonds reversed much of the gains they had made earlier in the day on news of the talks, as markets whipsawed to reflect the conflicting reports.
The protracted conflict between the US, Israel and Iran has upended the consensus view that both the Bank of England and America’s Federal Reserve would be able to cut their central interest rates on multiple occasions this year, easing the pressure on households and the government borrowing costs.
Movements point to four interest rate hikes
But the rout in short-dated UK bonds suggested traders were ready to price in as many as four interest rate hikes over the next 12 months, in a sign that elevated energy prices will feed through into inflationary pressure throughout the British economy.
“What we are witnessing is the early stage of a dangerous chain reaction,” said Nigel Green, chief executive of financial advisory firm Devere Group. “A spike in oil and gas prices is feeding directly into inflation expectations, and bond markets are responding fast.”
Iran has so far refused to heed any of Donald Trump’s demands to reopen the Strait of Hormuz, a vital shipping lane that funnels a fifth of the world’s oil and gas supply.
The US President on Saturday set the Iranian regime a 48-hour deadline to unblock the passage, promising to destroy much of its energy network were it to refuse. But Tehran has said it would destroy key infrastructure across the Middle East, in a move that would put historic upward pressure on global oil and gas prices.
“Three weeks ago, the market expected two rate cuts in the UK this year. We’re now looking at a situation where rates could be hiked four times by the end of 2026, according to market probability data,” said Russ Mould, investment director, AJ Bell.
“That has significant consequences for consumer and business spending, for the UK economy, and for public finances as the government’s cost of servicing debt would go up and tighten fiscal headroom.”
Early analysis conducted by Pantheon Macroeconomics suggests the market rout blew a £7bn hole in the UK’s public finances.
Sell-off evokes memories of Truss crisis
The sharp sell-off left the UK’s bonds on track for their worst month since Liz Truss’s fateful mini-Budget sparked a crisis in the UK gilt market. Truss’s radical fiscal event, which unleashed a wave of tax cuts and spending pledges in the midst of the 2022 energy shock, forced the Bank of England to stave off a full-blown market meltdown by buying up government bonds.
The episode, which was amplified by highly leveraged bets on short-term government bonds being made by pension funds, has drawn comparisons with the sudden changes in borrowings costs over the past few days.
Last year, Bank of England governor Andrew Bailey sounded the alarm on the growing proportion of UK sovereign bonds being owned by risk-seeking foreign hedge funds.
The UK government has become more reliant on a small number of little-known hedge funds to buy up its debt, after a shake-up in capital market regulation allowed pension funds and insurance firms to diversify away from the longer term bonds the government relies on selling.
Pension funds and insurers had tended to keep their bond holdings until they matured, and given their risk-averse mandates were not as likely to rack up debt to help fund investing elsewhere. But hedge funds, which largely operate on much shorter time frames, have increasingly taken out enormous bets on small price fluctuations in the UK bond market, which they then borrow against and reinvest to boost returns.