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On January 13, 2025, yield spreads between 10-year gilts and German Bunds reached 230 basis points. This is 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 his position is fragile. The Government must build confidence in the strength of the UK and in its own common sense.
Interest rates have increased across the G7. Even in Germany, the yield on the ultra-long 30-year Bund increased by 290 basis points between January 15, 2021 and January 15, 2025. In the United States, the increase was 300 basis points and in France 350 basis points. Sadly, the rise in UK yields was the highest in the G7, at 440 basis points. UK yields on 30-year government bonds reached 5.2 percent in mid-January. This is the highest level in the G7, while German yields were just 2.8 percent and French yields just 3.9 percent. But US yields were not that far behind those of the UK, at 4.9 per cent, likely due to the world’s economic superpower’s huge structural budget deficits.
In summary, long-term debt yields in the UK have increased further and reached higher levels than comparable countries. Yields on 30-year bonds were even 56 basis points higher than those in Italy on January 15. Additionally, while UK yields had risen by 78 basis points in the previous year, Italy’s yields did not rise at all. It’s embarrassing.
A crucial question is why rates have increased. The big change is in the real interest rate, not inflation expectations. In the case of the UK, we have reasonably robust measures of both, from the yields of indexed and conventional gilts. The difference between the two indicates inflation expectations and perceptions of inflationary risk.
This data shows that UK real interest rates rose from a low of -3.4 in early December 2021 to a high of 1.3% on January 14, 2025. This could be described as a normalization after a period of ultra-depressed real rates. The rise in real interest rates largely matches the rise in the yield of conventional gilts, suggesting that changes in inflation expectations have been surprisingly small.
So what do these real and nominal yields tell us about the stability of UK government debt? If the debt-to-GDP ratio is to be stabilized when the real interest rate exceeds the growth rate of the economy, the government must achieve a primary budget surplus (balance between revenues and expenditures before interest payments). A real rate of 1.3 percent allows for a modest primary deficit if growth is consistently higher than this figure. IMF data show that this was precisely the UK’s trend growth rate between 2007 and 2024. Thus, debt stability requires consistent primary balances. Fortunately, according to Office of Budget ResponsibilityAccording to the October budget analysis, the primary budget is expected to see a surplus of just under 1 percent of GDP in the last three years of this decade. This would be consistent with approximate stability in the net debt-to-GDP ratio, as shown by the OBR in its debt forecasts.
The implication is that the situation is manageable. However, there are risks. The first is that global real and nominal interest rates could rise further, perhaps due to further increases in investment or defense spending, or increased awareness of a host of political risks, monetary and financial. A specific fragility in the UK is that the country runs persistent capital account surpluses, making it heavily dependent on foreign financing, unlike, for example, Japan. This is also true for the United States. But the latter is the largest borrower in the rest of the world.
Another risk for the UK is that already weak GDP growth could slow further. The policy of generating primary budget surpluses could then become impossible. Another risk is that the net debt-to-GDP ratio is already close to 100 percent. That’s hardly low. It is comforting to see that it is below the levels of Japan, Italy, France and the United States. But this figure is much higher than twenty years ago. Finally, there is the “Trump risk,” notably the threat of high tariffs against an open economy that is no longer part of the EU.
In short, the situation in the United Kingdom is fragile. The government must maintain the confidence of its creditors. It is crucial not to adopt policies that raise doubts about their common sense. The way taxes were increased in the budget had exactly this effect. The same goes for the evolution of regulations, particularly in the labor market. The government will have to toughen its position on current expenses during its next review or consider higher taxes.
The UK must focus on resilience and growth. Panic is not necessary, but the era of cheap borrowing is over. Politics must react.