Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
On January 13 2025, spreads between yields on 10-year gilts and German Bunds reached 230 basis points. This was four basis points higher than the peak reached on September 27 2022, when Liz Truss was prime minister. The UK is probably not heading for a borrowing crisis. But its position is fragile. The government must reinforce confidence in the soundness of the UK and its own good sense.
Interest rates have risen across the G7. Even in Germany, the yield on the ultra-long 30-year Bund rose by 290 basis points between January 15 2021 and January 15 2025. In the US, the rise was 300 basis points, and in France 350 points. Alas, the rise in UK yields was the highest in the G7, at 440 basis points. UK yields on 30-year gilts reached 5.2 per cent in mid-January. This was the highest level in the G7, while German yields were only 2.8 per cent and French ones still only 3.9 per cent. But US yields were not so far behind UK levels, at 4.9 per cent, probably because of the huge structural fiscal deficits in the global economic superpower.
In sum, UK yields on long-term debt have risen by more and reached higher levels than in peer countries. Yields on 30-year gilts were even 56 basis points higher than Italy’s on January 15. Moreover, while UK yields had risen 78 basis points in the previous year, Italy’s did not rise at all. That is embarrassing.
A crucial question is why rates have risen. The big change has been in the real rate of interest, not inflation expectations. In the UK case, we have reasonably robust measures of both, from yields on index-linked and conventional gilts. The difference between the two indicates inflation expectations and perceptions of inflation risk.
These data show that real interest rates in the UK have jumped from a trough of -3.4 in early December 2021 to a peak of 1.3 per cent on January 14 2025. One might describe this as normalisation after a period of ultra-depressed real rates. The jump in real interest rates largely matches the rise in the yield on conventional gilts, which suggests that changes in inflation expectations have been surprisingly small.
So, what do these real and nominal yields tell one about the stability of UK public debt? If the ratio of debt to GDP is to be stabilised when the real rate of interest exceeds the growth rate of the economy, the government needs to run a primary fiscal surplus (balance between revenue and spending before interest payments). A real rate of 1.3 per cent allows a modest primary deficit if growth is consistently higher than that. IMF data show that this was precisely the trend rate of growth of the UK between 2007 and 2024. So, debt stability requires consistent primary balances. Happily, according to the Office for Budget Responsibility’s analysis of the October Budget, the primary budget is forecast to move into a surplus of a little under 1 per cent of GDP in the last three years of this decade. This would be consistent with rough stability of the ratio of net debt to GDP, as the OBR shows in its debt forecasts.
The implication is that the situation is manageable. Yet there are risks. One is that global real and nominal interest rates could shoot up further, perhaps because of further jumps in spending on investment or defence, or increased awareness of a host of political, monetary and financial risks. A UK-specific fragility is that the country runs persistent capital account surpluses, which make it highly dependent on foreign funding, unlike, say, Japan. This is also true for the US. But the latter is the prime borrower for the rest of the world.
Another risk for the UK is that GDP growth, already low, might slow even further. The politics of running primary fiscal surpluses might then become impossible. Yet another risk is that the ratio of net debt to GDP is already close to 100 per cent. This is hardly low. Comfortingly, it is below the levels in Japan, Italy, France and the US. But it is far higher than it was two decades ago. Finally, there is “Trump risk”, particularly threats of high tariffs against an open economy no longer inside the EU.
In brief, the UK’s situation is fragile. The government needs to retain the confidence of its creditors. It is crucial not to adopt policies that raise doubts about its good sense. How taxes were raised in the Budget did just that. So, too, do regulatory developments, notably in the labour market. The government will have to toughen its stance on current spending in its coming review or consider higher taxes.
The UK must focus on resilience and growth. Panic is unnecessary, but the era of cheap borrowing is over. Policy has to respond.
