Chancellor Rachel Reeves may need to cut spending after jump in borrowing costs

The cost of borrowing for the UK government surged to its highest level for almost 17 years on Wednesday amid a sell-off in the bond market and concerns over the threat of stagflation

Economists have warned that the Chancellor may be forced into further tax hikes or spending cuts to meet UK fiscal rules, following a surge in government borrowing costs.

This week, state borrowing costs hit their highest level in nearly 17 years due to a continued sell-off in the bond market and investor concerns over the threat of stagflation.

The increase in the cost of servicing government debts could eat into Labour’s expected financial headroom, potentially indicating how investors view fiscal sustainability in the UK. This also led to a drop in the value of the pound, which fell to its lowest level since April last year.

Sterling dropped by as much as 1.1% to 1.233 against the dollar on Wednesday. The yield on the benchmark 10-year UK gilt, reflecting the cost of government borrowing, rose by about 12 basis points to a peak of 4.81%.

This was the highest reading since the 2008 financial crisis. The rise in gilt yields inversely affected the price of these government bonds, which fell as a result on Wednesday.

The cost of longer-term borrowing also continued to rise, with the yield of 30-year gilts at their highest level since 1998. They were up around 10 basis points to a peak of 5.36%.

Globally, there has been a wider sell-off in government bonds in recent months due to worries that US President-elect Donald Trump could introduce a tariff policy which would be inflationary for many international economies.

US Treasury yields surged on Wednesday, with the 10-year yield hitting a peak of 4.69% – its loftiest point since April of the previous year. This sharp escalation followed reports suggesting the US economy's robust performance, fuelling scepticism over the likelihood of upcoming interest rate reductions.

Meanwhile, on home turf, the Debt Management Office (DMO) saw an uptick in yields as it offloaded £4.25bn worth of notes on Wednesday, following a £2.25bn sale just a day prior. Last year, predictions from the DMO forecasted around £296.9bn in note sales throughout the 2024-25 fiscal span.

Chancellor Rachel Reeves is now facing heightened hurdles due to climbing government borrowing costs—pressure that strains the Treasury's capacity to bolster public spending given rising interest expenses. Post-autumn Budget, Reeves had only £9.9bn in leeway for meeting her newly adjusted fiscal mandates, even after implementing a £40bn tax hike aimed at fuelling increased expenditure.

If debt interest costs continue their upward trajectory, the Chancellor might need to curtail spending or generate additional revenue to abide by the fiscal guidelines. Kallum Pickering, the chief economist at brokerage Peel Hunt, weighed in: "If bond yields rise further, Reeves may be forced to make the economically damaging decision of further increasing taxes or cutting back on planned public spending to balance the books."

Additionally, the Chancellor pledged last year to limit tax amendments to a single fiscal event annually.

The Treasury has declared that the Chancellor is committed to leaving "no stone unturned in her determination to deliver economic growth and fight for working people". A spokesperson said: "No one should be under any doubt that meeting the fiscal rules is non-negotiable and the Government will have an iron grip on the public finances,"

"UK debt is the second lowest in the G7 and only the OBR’s forecast can accurately predict how much headroom the government has – anything else is pure speculation."

The Prime Minister's official spokesman said: "I’m obviously not going to get ahead... it’s up to the OBR (Office for Budget Responsibility) to make their forecasts and they’ll make their forecasts at the spring statement in the usual way.

"But I would say when the Government came into office we made very clear why it’s so important to manage the public finances to deal with the £22bn black hole that was in the public finances, because having stability in the public finances is precursor to having economic stability and economic growth."

Meanwhile, Shadow chancellor Mel Stride criticised the Chancellor's financial strategy, claiming, "We should be building a more resilient economy, not raising taxes to pay for fiscal incompetence," and highlighted Labour's approach by saying, "Labour’s decision to allow debt to continue rising ever higher leaves us vulnerable even to small changes in markets."

Michiel Tukker, senior European rates strategist at ING, has cautioned that a drop in borrowing costs may not be immediate. He explained: "Myriad factors contributed to the stretch higher, including Labour’s spending ambitions, sticky inflation, higher US rates and supply pressures. We still see gilt yields settling lower later in the year, but as long as these factors linger, a change in direction may take some time."

Meanwhile, former cabinet secretary Lord Gus O’Donnell, who served under prime ministers Blair, Brown, and Cameron, said the current Number 10 requires "more intellectual heft" and "economic expertise" for the upcoming Spending Review. On LBC's Tonight with Andrew Marr show, he remarked: "They are going to have to be very tight on spending. This is going to be a pretty brutal Spending Review. There are going to be lots of departments who are upset... but it’s manageable,".

When questioned whether Downing Street possesses sufficient intellectual capacity for the review, O’Donnell frankly stated: "The answer is no, and it’s very clear. Who in No 10 has done a Spending Review before? I don’t know of anybody. " He insisted: "So, yes, they need more intellectual heft. They need more economic expertise."