Gilt trip: why markets are punishing Rachel Reeves
Without a credible and transparent medium-term fiscal plan, bond markets will continue to price in higher risk and demand higher returns, says Gareth Davies
The UK economy faces an uncomfortable reality. On one side, inflation has continued to rise. On the other, government borrowing costs have surged, with gilt yields now at their highest level in almost three decades. Taken together, these developments reflect a climate of uncertainty that investors and policymakers alike will find increasingly difficult to ignore.
The latest data from the Office for National Statistics shows that CPI rose by 3.8 per cent in July, up from 3.6 per cent the previous month, and is expected to reach four per cent in September. The drivers were largely concentrated in transport and services, with airfares jumping more than 30 per cent in a single month, the steepest July increase since records began in 2001. Food and non-alcoholic beverages also saw prices accelerate at an annual rate of 4.9 per cent, the highest in over a year. While housing-related inflation eased slightly, broad-based price pressures persist across the economy.
At the same time, the gilt market is signalling its concerns. Thirty year yields have risen above 5.6 per cent, a level not seen since 1998, while ten-year yields are also sharply higher. The rise reflects more than just expectations about the path of monetary policy. It is also a product of weaker demand from long-term institutional investors and an emerging UK risk premium, as markets question the credibility of the fiscal framework. Compared with other G7 countries, UK borrowing costs are rising faster, underscoring doubts about the direction of policy.
Thirty year yields have risen above 5.6 per cent, a level not seen since 1998, while ten-year yields are also sharply higher
The link between the two is clear. Inflation that proves stubborn and unpredictable delays the prospect of monetary easing which translates directly to higher gilt yields. The higher the cost of government borrowing, the greater the burden on taxpayers, with more money diverted into debt interest and less available for investment in infrastructure, services or other growth focused measures. This dynamic creates a vicious cycle: inflation keeps rates higher for longer, markets demand a higher risk premium and fiscal space is steadily eroded.
For investors the implications are serious. Gilt yields set the benchmark for the entire economy. Higher yields raise discount rates, depress asset valuations and increase the cost of leveraged transactions. At the sovereign level, they reduce flexibility and risk locking the UK into structurally higher financing costs for years to come. This is not just about a temporary market dislocation. It is about the long-term conditions for investment and growth.
Fiscal indiscipline
It is worth recalling where we were not so long ago. When I left the Treasury and Labour took office, inflation stood at two per cent. That outcome was the result of careful alignment between fiscal and monetary policy, and a commitment to fiscal discipline that markets recognised. Today, with inflation almost double that rate and borrowing costs at a generational high, the contrast is stark.
The government now faces a clear challenge. Without a credible and transparent medium-term fiscal plan, the market will continue to price in higher risk and demand higher returns. That means the cost of servicing debt will climb further, crowding out space for investment and public services.
There are steps that can and should be taken. The first is to realign fiscal and monetary policy. The Bank of England cannot fight inflation effectively if fiscal choices are working in the opposite direction. The government must show restraint on spending commitments that feed demand, such as public sector pay awards, and policies that increase the cost of supply, such as their broad tax rises. That discipline matters as much for confidence as it does for the inflation outlook itself – yet this point seems to be completely lost on this Chancellor.
Second, fiscal policy must be anchored in a clear medium-term framework that reassures investors. Markets need to see a path for debt sustainability that is not dependent on short-term fixes. Borrowing should be channelled towards projects that genuinely enhance long-term growth and productivity, not pet projects like the £8bn commitment for GB Energy.
Finally, the government needs to rebuild trust with markets. That means being clear, consistent, and disciplined in its communications and actions. Fiscal credibility is not a slogan; it is earned over time by demonstrating that choices today are consistent with stability tomorrow. If that is done, gilt yields will ease, inflation expectations will settle, and financial conditions will stabilise.
Gareth Davies MP is shadow financial secretary to the Treasury