UK government borrowing costs rose to their highest level in almost two decades on Tuesday, as growing speculation over the future of Prime Minister Sir Keir Starmer clashed with fresh inflation fears sparked by the Iran conflict, leaving the country's small and medium-sized businesses staring down the barrel of another period of tight debt and low costs.
The effective interest rate on 10-year gilts briefly touched 5.13% in morning trade, a level not seen since the depths of the 2008 global financial crisis. Yields on two-, five- and 30-year bonds rose again, with the 30-year average reaching 5.80% – the highest since 1998.
For Britain's 5.5 million SMEs, which are already facing stubborn input costs and a softening consumer, the movement in the bond market is not an invisible Westminster game. Two- and five-year yields directly support mortgage rates, and by increasing working capital pressures on owner-managers their homes and balance sheets remain tightly linked.
The FTSE 100 fell 0.5%, with top-tier banks leading the retreat amid talk that any successor boss could light new taxes on the sector. Sterling weakened by a similar margin against the dollar, falling to $1.35.
A toxic cocktail of geopolitics and Westminster jitters
Markets have been on edge for weeks as the war in Iran pushed the currency above $100 a barrel, threatening to reignite the very inflationary fires the Bank of England spent two years putting out. But while peer economies have weathered the oil shock with slow moves in their debt markets, British gilts have been punished.
The reason, according to City analysts, is politics. With Sir Keir's hold on No 10 looking fragile, his allies appeared at a cabinet meeting on Tuesday insisting the Prime Minister will “continue to govern”, investors are pricing in the real prospect of a leadership contest that could bring the slightly wedded Chancellor to the curb.
Sir Keir and Chancellor Rachel Reeves have spent the better part of a year repeating their commitment to “iron-clad” lending rules, a mantra designed to avoid bond monitoring. However, a growing chorus of supporters on the left of the party have begun to question whether the self-imposed restrictions are “fit for long-term renewal”.
Capital Economics puts this issue directly to clients. “The UK's already fragile financial position means investors will be watching for any signs of monetary easing,” its analysts wrote. “A possible Starmer/Reeves replacement would probably not be financially viable.” The company has flagged Andy Burnham, Angela Rayner and Wes Streeting, names often identified as potential challengers, as candidates “likely to raise public money”.
Why is Muzi scared
Anna Macdonald, director of investment strategy at Hargreaves Lansdown, said the gilts market had been “disturbed” by the prospect of a new Number 11 taking a more liberal view on public finances. “This could mean that investors, 25-30% of whom are overseas buyers of UK government bonds, are demanding a significant risk premium,” he warned.
That risk premium is significant beyond the trading floors of the Square Mile. Governments raise most of their revenue through taxation, but often spend more than the Exchequer takes in. The deficit is bridged by issuing gilts, IOUs sold to pension funds, insurance insurers and foreign investors, who, instead of parting with their money, want certainty above all else.
When that confidence evaporates, the cost of borrowing rises. And the bill for Britain's existing stock of public debt, already bloated by years of crisis-era spending – now costs around £1 in every £10 spent by the government. Each higher tick in wages translates directly into a smaller financial base for the productivity-enhancing investment SMEs have been seeking, from full-scale cost-cutting to business-level adjustments.
For owner-managers, rapid learning is threefold. Mortgage rates, which are already a drag on consumer discretion, are likely to remain strong for a long time. Sterling's weakness will sharpen the import bill for any business that relies on dollar imports, from manufacturers to hospitality operators who need food and drink from overseas. And the cost of corporate borrowing, whether it's long-term loans or equity financing, likely won't ease until the bond market recovers.
Until Westminster gives a clear answer to the question of who will be leading the country in the autumn, that relief looks remote.
