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The spread between UK and US government borrowing costs widened to its highest in almost a year this week as investors bet that a tougher inflation outlook and economic recovery will keep UK interest rates high for longer.
The yield on 10-year government bonds rose above 4 percent this week, pushing the gap between benchmark UK and US borrowing costs to 0.18 percentage points.
Before Friday’s small pullback, it was the highest since last September. Until early August, the yield on the benchmark US Treasury bond had been higher than the yield on the UK bond through 2024.
The rise in UK borrowing costs partly reflects concerns about persistent domestic service inflation and a recovering economy that is keeping interest rates high.
UK government bond prices have also lagged behind European counterparts this month as investors bet that weaker inflation data in the euro zone will boost the chances of the European Central Bank cutting interest rates multiple times this year.
“Going into the new year, there was a consensus that the UK was going to be hit by a recession and government bonds became the consensus[buy]“This year, we proved that wrong,” said Shamil Gohil, portfolio manager at Fidelity International.
“Steady services inflation, high wages and revised GDP all point to strong UK data and a gradual Bank of England rate-cutting cycle,” he added.
Traders in the swaps market expect the BoE to make one or two more rate cuts of 0.25 percentage points each this year, compared with two or three cuts by the ECB and a one percentage point cut by the Federal Reserve.
The strong performance in US Treasuries comes after Fed chairman Jay Powell told a summit last week that the “time is right” for the US to cut interest rates while Andrew Bailey, governor of the BoE, warned that it was “too early to declare victory over inflation” in the UK.
UK services inflation remains high, despite recent improvements. Inflation was 5.2 per cent in the year to July, compared with 4.9 per cent in the US. Eurozone services inflation was 4.2 per cent in August.
Economists are also cautious that UK interest rates will remain high while the economy recovers. After falling into recession last year, it has grown for consecutive quarters. Analysts now forecast the UK economy will grow by 1.3 per cent in 2025, up from an estimate of 1.1 per cent at the start of this year.
“Stronger growth in the UK… could pose inflation risks, potentially limiting the BoE’s ability to cut interest rates,” said Jason Da Silva, director at Arbuthnot Latham.
Some investors warn that the large bond supply is also weighing on government bond yields. The government issued £3.1 billion of debt in July, well above the £0.1 billion forecast by the Office for Budget Responsibility, the UK’s financial watchdog, and the £1.5 billion forecast by economists polled by Reuters.
“There has been some fiscal slippage in the deficit… which is likely to put pressure on government bonds,” said Peder Beck-Friis, an economist at Pimco.
The government could also announce more borrowing in the upcoming budget. “The new Labour government has had a difficult start to its tenure, highlighting the bleak state of the public finances while simultaneously making matters worse by increasing public sector pay,” said Craig Inches, director of rates and cash at Royal London Asset Management.
This “could lead to more borrowing, in effect increasing the already bloated supply of UK government bonds,” he added.
