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The premium on UK government borrowing costs over the US rose to its highest level for almost a year this week as investors bet that a more tricky inflation outlook and a rebound in the economy will keep UK interest rates higher for longer.
The yield on 10-year gilts rose to more than 4 per cent this week, pushing the gap between benchmark UK and US borrowing costs to 0.18 percentage points.
Before Friday’s small pullback, that marked the highest level since September last year. Until the start of August benchmark US Treasury yields had been higher than their UK counterparts throughout 2024.
The rise in UK borrowing costs in part reflects concern about lingering domestic-services inflation and a resilient economy keeping interest rates elevated.
UK government debt prices have also lagged their European counterparts this month as investors bet that softer inflation data around the eurozone would boost the chances of multiple rate cuts by the European Central Bank this year.
“Coming into the year there was a consensus that the UK would be hit by a recession and gilts became a consensus [buy] . . . This year we’ve been proven wrong,” said Shamil Gohil, a portfolio manager at Fidelity International.
“Sticky services inflation, strong wages and revised GDP all point towards robust data in the UK and a Bank of England cutting cycle that will be gradual,” he added.
Traders in swaps markets expect the BoE will deliver one or two more quarter-point rate cuts this year, compared with two or three for the ECB and a percentage point of cuts by the Federal Reserve.
The strong performance of US Treasuries comes after Fed chair Jay Powell said at a summit last week that the “time has come” for US rate cuts while Andrew Bailey, BoE governor, warned it was “too early to declare victory over inflation” in Britain.
UK services inflation has remained stubbornly high, in spite of recent improvements. It was 5.2 per cent for the year to July, compared with 4.9 per cent in the US. The eurozone services inflation in August was 4.2 per cent.
Economists are also wary that UK interest rates will remain elevated while the economy remains resilient. After slipping 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 a 1.1 per cent estimate earlier this year.
“Stronger UK growth . . . could introduce upside risks to inflation, potentially limiting the BoE’s ability to reduce interest rates,” said Jason Da Silva, a director at Arbuthnot Latham.
Some investors warn that heavy bond supply is also weighing on gilt yields. The government issued £3.1bn of debt in July, much more than the £0.1bn forecast by the Office for Budget Responsibility, the UK fiscal watchdog, and the £1.5bn predicted by economists polled by Reuters.
“There has been some fiscal slippage in the deficit . . . likely weighing on gilts,” said Peder Beck-Friis, an economist at Pimco.
The government might also announce more borrowing in its upcoming budget. “The new Labour government has had a tough start to its tenure, highlighting the dismal state of public finances whilst at the same time making matters worse by increasing public sector pay,” said Craig Inches, head of rates and cash at Royal London Asset Management.
He added that this “could result in higher borrowing, in effect increasing an already bloated UK gilt supply.”