As the recent rise in bond yields has impacted the government’s finances, the UK paid the highest borrowing costs on two-year bonds this century.
Gilt Prices have fallen in recent weeks, pushing yields higher as expectations of stubbornly high inflation increase that the Bank of England may have to raise rates further to control rising prices.
The Wednesday sale of a gilt that matures in October 2025, priced at a yield 5.668 percent, was the most expensive two-year borrowing since UK Debt Management Office began in 1998. This was the highest yield of any debt issued by the UK since 2007, when a five year gilt was sold at a slightly lower yield.
The Treasury’s interest rates have increased rapidly since the bond first was issued in January of this year.
Mark Dowding is chief investment officer of RBC BlueBay Asset Management. He said that the government finances do not look good. “Higher debt service costs are becoming an important factor when it comes to fiscal spending – they limit the ability of government to spend money on the NHS and key public services.” Last month, the BoE surprised investors by increasing borrowing costs by 0.5 percent points. This was more than what most investors had expected. It also put more pressure on short term gilts which are sensitive to expectations of interest rates.
Investors are convinced by the BoE’s unexpectedly aggressive response that it will continue to raise rates until consumer prices begin to decline. Swaps market pricing now indicates that UK interest rates are expected to peak at 6.25 percent early next year.
JPMorgan’s Allan Monks, a JPMorgan economist, said in a note to clients that the BoE may be forced to raise rates to as high as 7% if inflation is even more stubborn than anticipated. However, his main expectation is still for rates to peak at 5.75 percent in November.
Andrew Bailey, the governor of the Bank of England (BoE), said that the bank will be “evidence driven” when setting interest rates. He also stated that the bank is looking at the peak rates as well as “how long the peak persists after that”.
Core inflation, which excludes volatile energy and food prices, and is seen as a more accurate indicator of price pressures, increased faster than expected to 7.1%.
The yield of the two-year bonds issued in Wednesday’s auction also represented a substantial premium over the UK’s two-year benchmark bond, which currently yields 5.3% on the secondary market.
Analysts say that since the BoE has stopped purchasing large chunks UK debt as part of its quantitative easing program, bonds such as those sold on Wednesday are trading with higher yield premiums. This is because there is less demand for them.
Megum Muhic is a strategist with RBC Capital Markets. She said, “It has been a trend since 2022 – bond prices are quite low compared to other bonds.”
The UK government is under pressure to reduce borrowing costs as it plans to issue £241bn in gilts during the current financial period. This represents a significant increase over the £139.2bn that was issued in the previous financial year.
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