The UK bond squeeze is slowly pushing Britain towards a repeat of the turmoil seen during Liz Truss’s 2022 mini-Budget.
As it stands, the 10-year gilt yield sits at around 5.25%, its highest level since 2008. The 30-year gilt yield also reached 5.89% earlier this month, a level not seen since 1998.
Both yields have now climbed above the peaks that triggered emergency action from the Bank of England four years ago.
As I was quoted by Daily Express, The Financial, City News, Business Money, and Share Café, amongst others, the UK bond market is gradually putting the country’s public finances under the same kind of pressure seen during the 2022 mini-Budget crisis, leaving Chancellor John Healey to approach his first Budget on 28 October with considerably less fiscal room than the official forecasts might suggest.
The turmoil surrounding Liz Truss unfolded within days, making its impact impossible to miss.
These latest pressures are building much more gradually, but that does not mean the eventual consequences will be any less severe.
Borrowing costs have already risen beyond the levels seen when markets were thrown into turmoil in 2022.
The difference this time is that there is no single dramatic event or policy announcement to mark the moment when things changed.
The pressure is accumulating steadily, day by day, and is increasingly being felt in the Chancellor’s already limited room for manoeuvre.
Rising Gilt Yields Squeeze UK Fiscal Headroom
The UK bond squeeze has already reduced estimated fiscal headroom from around £26 billion to £13.8 billion, despite no new spending commitments or tax cuts being announced.
And every further rise in yields pushes up the government’s debt servicing costs, eroding that financial buffer before Healey has even delivered his first Budget.
The Chancellor has already seen almost half of his fiscal headroom disappear, and he has yet to stand at the despatch box to deliver the Budget.
In many ways, the bond market is already shaping the first draft.
Every additional basis point of yield makes the government’s fiscal calculations more difficult, while any tax increases or spending restraint will be assessed against a market that has already repriced significantly.
The turmoil under Liz Truss could ultimately be reversed through a change of direction and a new Chancellor.
A gradual repricing in the bond market offers no comparable escape route.
Why Long-Dated UK Gilts Are Under Pressure
The Bank of England’s decision to stop selling very long-dated gilts as part of its quantitative tightening programme suggests that this end of the yield curve is already being viewed as a particular pressure point.
It is the same part of the market that came under severe strain in 2022, when pension funds were forced into large-scale gilt sales.
Today, the pool of traditional buyers of long-dated government bonds is becoming smaller, while the government’s borrowing requirements remain substantial.
In 2022, the immediate response was a policy U-turn and a change at the Treasury. There is no comparable quick fix this time.
A sustained market trend cannot simply be reversed overnight. Traditional buyers of long-dated government debt are becoming less prominent, supply remains elevated, and global bond markets are already showing signs of nervousness.
Together, these factors create a potentially combustible combination.
Global factors are also pushing bond yields higher, from renewed inflation concerns and elevated oil prices to tighter monetary policy in Japan and the US.
But the UK is particularly exposed when market sentiment deteriorates, given Bank Rate is at 3.75%, fiscal headroom is narrowing and the Budget is approaching.
Bank Rate is now significantly above its 2022 level, yet long-dated gilt yields continue to rise.
That divergence highlights the degree of risk investors are increasingly demanding to hold UK government debt.
What Higher Gilt Yields Mean for the UK Economy
The impact will not be confined to Whitehall.
Higher gilt yields can feed through into mortgage rates, corporate borrowing costs and pension valuations, extending the pressure to households and businesses across the economy.
Global bond markets are setting the broader direction, but the UK bond squeeze is being intensified by the country’s own vulnerabilities.
Those vulnerabilities will face a crucial test when the Chancellor delivers the Budget on 28 October.
If the Budget fails to reassure bond investors that the government’s finances are credible and the numbers stack up, today’s steady pressure could quickly intensify.
It does not take much to unsettle the gilt market. A loss of investor confidence could trigger a sharper rise in yields and bring the so-called bond vigilantes back into focus.
The turmoil surrounding the Truss mini-Budget demonstrated just how quickly investor confidence can deteriorate when markets lose faith in the government’s fiscal calculations.
My concern now is that Healey must convince investors of the credibility of the numbers before market sentiment deteriorates further.
Several important questions will be answered by the Budget. How much fiscal consolidation will it deliver, and will investors view the measures as credible? Can the government’s fiscal rules withstand pressure from a bond market demanding greater compensation for holding UK debt? And, crucially, can the Chancellor restore some of his fiscal headroom without putting unnecessary pressure on economic growth?
The bond market will ultimately determine whether the Budget is credible and whether the numbers stand up to scrutiny.
Right now, investors are taking a highly cautious view of the government’s fiscal position.
To read my previous blog post, click here.