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On January 13 2025, the spread between the yield on 10-year gilts and German Bunds reached 230 basis points. This was four points higher than the peak reached on September 27 2022, when Liz Truss was prime minister. The UK is probably not going into a debt crisis. But its place is weak. The government needs to strengthen confidence in the soundness of the UK and its good sense.
Interest rates rose in the G7. Also in Germany, the yield on the Ultra-long 30-year Bund increased by 290 points between January 15 2021 and January 15 2025. In the US, the increase was 300 points, and in France 350 points. Alas, the rise in UK yields was the highest in the G7, at 440 points. UK yields on 30-year gilts reached 5.2 per cent in mid-January. This was the highest level in the G7, while German yields were only 2.8 percent and the French were only 3.9 percent. But US yields were not that far off UK levels, at 4.9 per cent, perhaps due to the large financial deficit in the global economy.
Overall, UK yields on long-term debt rose more and reached higher levels than in other countries. Yields on 30-year gilts were up to 56 basis points higher than in Italy on January 15. Moreover, while UK yields rose by 78 basis points last year, Italy's did not rise at all. That is embarrassing.
The important question is why the rates have gone up. The biggest change has been in the real interest rate, not inflation expectations. In the UK context, we have strong measures of both, from index-linked products and conventional gilts. The difference between the two reflects inflation expectations and inflation risk perceptions.
These data show that real interest rates in the UK jumped from a trough of -3.4 at the beginning of December 2021 to a peak of 1.3 percent on January 14 2025. One can explain this as a normal thing after the period of ultra-depressed real rates. The jump in real interest rates largely coincided with the rise in yields on conventional gilts, suggesting that changes in inflation expectations have been surprisingly small.
So, what do these real and marginal yields tell one about the sustainability of UK government debt? If the debt-to-GDP ratio is to be stabilized when the real rate of interest exceeds the rate of economic growth, the government must run a primary fiscal surplus (the balance between income and expenditure before interest payments). A real rate of 1.3 percent allows for a lower deficit if growth remains higher than that. IMF data show that this was the correct growth pattern for the UK between 2007 and 2024. Happily, according to the Office of Budget ResponsibilityAnalysis of the October Budget, the main budget is estimated to be in surplus of slightly less than 1 percent of GDP in the last three years of the decade. This would be consistent with the rough stability of the debt-to-GDP ratio, as the OBR shows in its debt forecast.
The implication is that the situation is manageable. Yet there are risks. One is that real interest rates around the world may rise further, perhaps due to a further jump in investment or defense spending, or increased awareness of a range of political, monetary and financial risks. A particular weakness in the UK is that the country runs a capital account surplus, which makes it highly dependent on foreign funding, unlike, say, Japan. This is also true in the US. But the latter is the biggest borrower in the world.
Another risk for the UK is that GDP growth, which is already low, could slow further. The politics of running a primary fiscal surplus may not be possible. Yet another risk is that the debt-to-GDP ratio is already close to 100 percent. This is almost the bottom. Comfortably, it is below the levels of Japan, Italy, France and the US. But it is much higher than it was two decades ago. Finally, there is the “Trump risk”, especially the threat of higher tariffs against an open economy no longer within the EU.
In short, the UK situation is weak. The government must maintain the credibility of the lenders. It is important not to follow policies that raise doubts about their good sense. The tax hike in the Budget does just that. Therefore, it does management development, especially in the labor market. The government will have to strengthen its position current expenditure in its next review or consider higher rates.
The UK should focus on sustainability and growth. There is no need to panic, but the era of cheap loans is over. Policy must be responsive.