Why are UK borrowing costs rising and what does it mean for me?

In recent months, the government's borrowing costs have steadily increased, reaching their highest levels in years. This phenomenon has sparked widespread concern. What exactly is causing this situation, and what impact will it have on the public?

Bonds are similar to IOUs that can be traded on financial markets. Governments often spend more than they collect in tax revenue, so they need to borrow money from investors by issuing bonds to make up the difference. In addition to eventually repaying the principal of the bond, the government also makes regular interest payments, providing investors with a continuous stream of future income. UK government bonds, known as "gilts," are generally considered very low-risk investments, mainly purchased by financial institutions such as pension funds.

Since about August, the interest rates (also known as yields) on government bonds have been rising. The yield on 10-year bonds has soared to its highest level since 2008, while the yield on 30-year bonds has reached its highest point since 1998, meaning the government's long-term borrowing costs are increasing. At the same time, the pound's exchange rate against the US dollar has also fallen in the past few days. On Tuesday, the pound was worth $1.25 against the dollar, while it is currently trading at $1.23.

The rise in yields is not unique to the UK. Borrowing costs are also rising in countries such as the US, Japan, Germany, and France. This is linked to President-elect Donald Trump's upcoming return to the White House. Investors are concerned that his promised policies of imposing tariffs on goods entering the US and cutting taxes will lead to more persistent inflation than expected, preventing interest rates from falling as quickly as they had anticipated. Additionally, concerns have been raised about the UK's poor economic performance. Inflation has reached its highest level in eight months, reaching 2.6% in November, above the Bank of England's 2% target. Meanwhile, the UK economy has contracted for two consecutive months.

Analysts believe that it is these broader concerns about economic strength that are weighing down the pound, which would typically strengthen when borrowing costs rise. Chancellor Rachel Reeves has pledged that all day-to-day spending should be funded by taxes, not borrowing. However, if she needs more money to repay higher borrowing costs, it will consume more tax revenue, leaving less for other spending. Economists warn that this could mean cuts to public services and tax increases, which will impact people's wages or businesses' growth and hiring abilities.

The government has committed to holding only one fiscal event per year, during which it can increase taxes, and the next fiscal event is expected to take place in the autumn. Therefore, if higher borrowing costs persist, we may see spending cuts sooner, or at least spending growth will be lower than expected. Some may be concerned about the impact of higher gilt yields on the mortgage market, especially given what happened after Liz Truss's mini-budget in September 2022. While yields are now higher than they were then, they have risen slowly over several months, whereas in 2022 they rose sharply in a matter of days. This rapid increase led lenders to quickly withdraw deals while trying to determine what interest rates to charge.

Analysts and brokers say that the current market unease is having some impact on mortgage pricing. Many had expected interest rates to fall at the beginning of the year, but lenders are holding back, waiting to see before cutting rates. However, the market is currently favorable for those buying annuities, which are a one-time purchase of a lifetime retirement income. One annuity expert told the BBC that many people will now get the best deals since 2008. The Treasury has said there is no need for urgent intervention in financial markets. It stated that it will not make any announcements on spending or tax until its independent watchdog, the Office for Budget Responsibility (OBR), publishes its official borrowing forecasts on March 26.

If the OBR says that the Chancellor is still on track to meet her own fiscal rules, this may stabilize the markets. However, if the OBR says that the Chancellor is likely to breach her fiscal rules because of slower economic growth and higher-than-expected interest rates, then this could cause problems for Reeves.