Pressure to make cuts in public spending has intensified in recent weeks, with increased calls on Prime Minister Andy Burnham to find savings urgently.
The need to reduce expenditure has become more pressing as the cost of loans used to pay for services has shot up.
With the bill on the government’s borrowing rising sharply there is less room for manoeuvre in the public finances ahead of new Chancellor John Healey’s first budget on October 28.
So, why is this happening, and what is causing the interest to grow so quickly?
When governments borrow money, they do this by issuing bonds. These are essentially IOUs in which the government agrees to pay back the borrowed sum on a certain date, with interest paid in the meantime. These bonds are then bought by a range of investors, including pension and insurance companies, commercial and central banks, hedge funds and private investors.
As these bonds change in value according to market fluctuations, their cost to the government varies. The amount in yields paid to investors on the bonds goes up or down accordingly, and when the yields rise it is more expensive to issue new bonds.
Long-term bond yields have risen to multi-decade highs. The UK is not alone in seeing such expensive yields and, therefore, high government borrowing costs, but has seen the largest rises among major economies.
The UK is experiencing a notable switch from low to highest rates. These higher yields have implications across the economy, including for government spending and tax decisions, investment by firms and mortgage rates for households.
Spending scrutinised
The question is why are yields rising, especially for the UK?
The level of government debt is at record highs. The US has just passed £29.6 trillion, the UK owes around £3 trillion, Japan £6 trillion and France over £2.5 trillion.
These levels of government debt have worried the market and investors because of concerns about the ability of governments to repay the loans. While debt rose through policy responses to the financial crisis in 2008-09 and the Covid pandemic with little impact on long-term yields, markets are now scrutinising current government spending closely.
This was seen with the Liz Truss “mini-budget” of September 2022 and when Keir Starmer reversed proposed welfare cuts. In each case, the UK bond yield rose noticeably. This is now an issue confronting the new Burnham government that has already committed to higher spending such as a VAT cut on energy bills, a bus fare cap, a rough sleeper commitment, council house expansion, and an increased defence budget.
With the autumn budget coming up, bond markets are sending a warning shot to the UK government to present a plan to control spending. The UK has the highest long-term bond yields of comparable countries as a result of a greater sell-off of UK bonds by investors worried about a new bout of government borrowing.
Bond markets are reflecting concerns that the UK government may seek to cover some of its increased spending though higher tax rates, which will have a dampening effect on future economic growth and employment.
Debt is not the only reason behind the increase in bond yields. Higher inflation and the view that it may remain elevated, largely due to the re-escalation of the Iran conflict and associated higher energy costs, also contributes.
The increase in Middle East hostilities has seen the crude oil price rise around 30% in the last two months, from the high US$60s (£44) in early July to near US$90 now. In the UK, the effects of higher oil and gas prices are seen in the energy price cap, which has recently risen and is expected to do so again.
The effect of the Iran conflict and restrictions on cargo passing through the Strait of Hormuz have broad effects across fuel, energy, shipping and food prices. This drives up inflation and expectations for future inflation. This may also lead to increases in the Bank of England base interest rate, which directly affects mortgages. Cuts in the rate expected at the start of the year will certainly not materialise.
There is a further factor driving up bond yields. While governments are issuing bonds to cover spending gaps, technology firms are also issuing bonds in order to invest in AI, because they believe that this sector will see large future growth. This year, to date, tech companies have issued US$220 billion in debt.
This all adds to the total amount of bond supply, resulting in investors requiring higher returns.
This brings us back to the budget next month. The bond market is sending a clear signal that the UK needs to control spending given its current level of debt, its exposed position to inflation and global energy prices plus the uncertain outlook for sustained economic growth. This creates difficult choices for the new prime minister and chancellor.
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