The ‘Perfect Storm’ Hanging Over Britain’s Public Debt

Even in a global energy crisis, Britain’s economic struggles stand out. The government’s borrowing costs have climbed to the highest level in three decades, faster than other European and American bond markets.

As the British public goes to the polls in local elections on Thursday, rising bond yields are an ominous signal for the government, which is bracing for a bruising outcome in the vote. Bond investors are fretting about the fragility of the country’s political and economic outlook as debt levels are high and inflation is accelerating.

This week, the yield on 30-year government bonds, known as gilts, climbed above 5.7 percent, the highest since 1998. The benchmark 10-year bond yield was close to 5 percent and has risen almost half a percentage point this year. By comparison, the yield on 10-year U.S. Treasuries has increased less than 0.2 percentage points. The move is three times as large as the one in German bunds.

“It’s a perfect storm for the U.K.,” said Katharine Neiss, the chief European economist at PGIM Fixed Income.

She cited three factors reinforcing one another: Britain’s fiscal and economic paths, its vulnerability to outside energy shocks because of its dependence on imported oil and gas, and its ongoing political uncertainty.

Some of this economic tumult is shared by governments all around the world. The effective closure of the Strait of Hormuz has sent energy prices surging. That is feeding into higher inflation and, for many governments, pressure to spend heavily to shield households and businesses, potentially borrowing more to do so.

Britain, though, is starting from a painful point.

At the outset of the war in the Middle East, inflation was 3 percent, a full percentage point above the central bank’s 2 percent target. And so interest rates were relatively high to squash lingering inflationary pressures. The government, led by Prime Minister Keir Starmer, was deeply unpopular. It was trying to rein in welfare spending, and had raised taxes to support investments and public services, while also trying to bring down debt levels. It was a complicated calculus that left Mr. Starmer’s opponents, as well as members of his Labour Party, dissatisfied.

That said, there had been signs the economic outlook was getting brighter. Inflation was forecast to drop sharply in April, and the central bank, the Bank of England, said it expected to keep cutting interest rates. Lower rates would have eased how much the Treasury was spending on debt interest payments. Another positive indicator: The government borrowed less than it expected in the last fiscal year, through March, recent data showed.

But then the war crushed these green shoots. Inflation jumped to 3.3 percent in March and is now expected to accelerate this year. Investors quickly dropped their expectations that the central bank would cut rates, instead betting on several rate increases the rest of the year. Mortgage rates and other borrowing costs went up. The International Monetary Fund slashed its forecast for Britain’s economic growth to 0.8 percent this year, from a previous projection of 1.3 percent.

Now there is the risk of a “negative spiral,” Ms. Neiss said, “where higher inflation means interest rates need to be higher, which means that fiscal pressures are tighter.” That leads to more difficult political decisions on tax and spending, “which makes the current leadership more vulnerable,” she added.

Some economists, including Ms. Neiss, believe that investors are overdoing their bets for multiple interest rate rises this year. They argue that the labor market has cooled and that there is less scope for workers to demand higher wages and for companies to aggressively raise prices, minimizing the chances of a devastating inflation spike. In addition, the energy shock could weigh heavily on demand, which itself would lower price pressures. Andrew Bailey, the governor of the Bank of England, also said last week that these economic conditions could make workers and companies cautious.

To date, investors have not rejected British assets. The pound has gained against both the U.S. dollar and the euro this year. A sale of 15 billion pounds of 10-year bonds was met with record investor demand last month. But traders are demanding higher returns for the debt. The yield on the sale was 4.92 percent, the highest since 2008.

For the government, the higher cost of borrowing maintains pressure when investors are watching the local election results. Expectations are high — in betting markets and elsewhere — that Mr. Starmer will not see out the year as prime minister. If he is replaced by a lawmaker from Labour’s left, investors worry the government could loosen the purse strings and worsen Britain’s debt trajectory.

That could undermine the potential for future interest rate cuts or a recovery in economy growth, Andrew Wishart, an economist at Berenberg, said in a research note. “However, bond markets and electoral considerations will discipline any prime minister.”