Pound falls and bond yields rise but UK rules out emergency action

The pound has fallen to its lowest level in over a year, while borrowing costs in the UK have reached a 16-year high. Economists are warning that rising borrowing costs could lead the government to further increase taxes or cut spending in order to adhere to its self-imposed rule of not borrowing to fund day-to-day expenditure.

Responding to an urgent question in the House of Commons, Treasury Minister Darren Jones stated that "there is no need for an emergency intervention" and that markets are "continuing to operate in an orderly way." However, Shadow Chancellor Mel Stride said: "Higher debt and lower growth are undoubtedly causing real concern for the public, businesses and the markets."

Jones pointed out that "it is normal for prices and yields on government bonds to fluctuate when there is wider volatility in global financial markets, including in reaction to economic data." He also added that the government's decision to only borrow for investment was "non-negotiable." But Stride argued: "The government's decision to let borrowing run means that their own tax rises will ultimately be swallowed up by higher borrowing costs, and the British people will not benefit."

On Thursday, the pound fell 0.9% against the dollar, to $1.226. Borrowing costs rose sharply earlier in the day but had eased back by mid-afternoon. Typically, when borrowing costs rise, the pound strengthens, but economists say that wider concerns about the strength of the UK economy are causing the pound to fall.

Governments typically spend more than they receive in tax revenue. To cover this shortfall, governments borrow money, but this borrowing must be repaid, with interest. One way governments borrow is by selling financial products called bonds. Allianz's chief economic advisor, Mohamed El-Erian, told the BBC's Today program that rising borrowing costs mean that the amount of interest the government pays on its debt increases, "eating up more tax revenue and leaving less money for other things."

El-Erian added that this also slows economic growth, "which also hurts revenue." "So if this persists, the chancellor will have to think about raising taxes or cutting spending further - and that's going to affect everyone," he said. The government has said it will not reveal any information about spending or taxes until its independent forecaster releases official borrowing predictions in March.

Revised figures showed the economy had zero growth between July and September last year. This was the latest in a string of disappointing figures, including a rise in inflation in November, with prices rising at their fastest rate since March. In December, the Bank of England said the economy was likely to perform worse than expected in the final three months of 2024. At the same time, it held interest rates at 4.75%, citing "high levels of uncertainty in the economy."

Globally, government borrowing costs have risen in recent months amid investor concerns that US President-elect Donald Trump's plans to impose new tariffs on imports from Canada, Mexico and China will push up inflation. US government borrowing costs have also seen similar increases to those in the UK. "It may be a global sell-off, but it presents a unique problem for the UK chancellor who wants to put more money into public services without raising taxes again or breaching her self-imposed fiscal rules," said AJ Bell's head of financial analysis, Danni Hewson.

Some may wonder about the impact of higher government bond yields on the mortgage market, following Liz Truss's mini-budget in September 2022. While yields are higher now than they were then, they have risen slowly over a period of months, whereas in 2022, they soared within days. This rapid increase caused lenders to quickly withdraw deals as they tried to work out how much interest to charge.

But Panmure Gordon's chief economist, Simon French, said the situation was too complex to directly compare Truss's and Reeves's situations. "The main driver of higher yields under Truss was UK policy. It was a combination of the mini-budget (which was her fault) and the energy crisis (which was not her fault). But the mini-budget was the biggest factor."

"This time, global concerns about debt levels are pushing yields higher everywhere, especially in the US, which is not Reeves's fault. But there are also concerns about the impact of her budget on growth, which is slowing rather than accelerating the economy. That is her fault."