Borrowing costs fall after inflation surprise

Due to unexpected declines in inflation in the UK and the US, markets are betting that central banks will cut interest rates in the coming months, leading to a significant drop in the UK government's borrowing costs. Key UK government bond yields, which represent interest rates, fell below 4.8% after previously hitting a 16-year high, reversing a surge from the previous week.

These shifts stem from new data showing that UK inflation fell to 2.5% in December, down from 2.6% the previous month. This has eased pressure on Chancellor Rachel Reeves, whose budget policies had been criticized for exacerbating market volatility. Last week, UK bond yields had surged to their highest level since 2008 amid growing concerns about the UK's economic outlook and rising borrowing costs. The yield on 10-year UK gilts had approached 4.9%, reflecting investor unease.

However, government data released on Wednesday, showing inflation falling for the first time in three months, appears to have calmed markets to some extent. Analysts suggest that the easing of inflation will provide the Bank of England with more leeway to consider further interest rate cuts to support the economy. On Wednesday, investors increased their bets on the possibility of a rate cut next month and backed further cuts by the end of the year.

US inflation news also boosted bets on lower borrowing costs, with data showing that the pace of underlying price increases in the US is slowing. A monthly report from the Labor Department showed that overall inflation rose from 2.7% to 2.9% in December. But markets focused on so-called "core inflation," which excludes volatile food and energy costs and is considered a better measure of trends. This measure unexpectedly fell from 3.3% to 3.2%, raising hopes that the US central bank will cut rates in the coming months.

Share prices rose and US yields fell, and these shifts quickly rippled through global bond markets, which had seen borrowing costs rise due to US economic dynamics. In addition to the UK, government bond yields in countries such as Germany also declined. The pound also rose to around $1.22 against the dollar on the news. However, Susannah Streeter, head of money and markets at Hargreaves Lansdown, cautioned that despite today's relief, UK borrowing costs remain high. “Government borrowing costs have started to edge down, with 10-year gilt yields also falling, but they remain above 4.8%, at decades-high levels, as investors assess the UK’s debt burden,” she said.