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The spread between UK government bond yields and US Treasuries reached its highest level in almost a year as investors anticipate a challenging inflation outlook and a recovering economy that will likely maintain higher UK interest rates.
This week, the yield on 10-year gilts surpassed 4%, widening the gap with US borrowing costs to 0.18 percentage points, the highest since September last year. UK borrowing costs have been higher than US Treasury yields throughout 2024, reflecting concerns about persistent domestic-services inflation and a strong economy supporting elevated interest rates.
UK government debt prices have underperformed European counterparts recently, as investors speculate that softer inflation data in the eurozone could lead to multiple rate cuts by the European Central Bank. The unexpected resilience of the UK economy has defied earlier recession forecasts, with indicators such as sticky services inflation, robust wages, and revised GDP pointing towards a gradual Bank of England cutting cycle.
Market expectations suggest that the BoE may implement one or two more quarter-point rate cuts this year, compared to projections of two or three cuts by the ECB and a percentage point reduction by the Federal Reserve. The positive performance of US Treasuries follows signals from Fed chair Jay Powell about impending rate cuts, while BoE governor Andrew Bailey remains cautious about declaring victory over inflation in the UK.
Despite recent improvements, UK services inflation remains notably higher at 5.2% for the year to July compared to 4.9% in the US and 4.2% in the eurozone for August. Analysts caution that elevated UK interest rates could persist as long as the economy continues to show resilience, with GDP growth forecasts revised upwards to 1.3% for 2025.
Concerns about heavy bond supply have also weighed on gilt yields, exacerbated by the government’s issuance of £3.1bn in debt in July, surpassing forecasts by fiscal watchdogs and economists. The potential for additional borrowing in the upcoming budget could further strain gilt yields, particularly as public finances face challenges amidst increased public sector spending.