UK Gilt Yield Premium and Fiscal Challenges Amid Market Uncertainties
UK 10-year gilt yields remain around 70 basis points higher than US Treasuries and approximately 25 basis points above eurozone yields. While there has been some relative improvement recently, the yield premium persists. According to an IPPR estimate, if this premium were to fall to zero, the UK Treasury could save up to £7bn annually until 2029-30.
The premium is only partly explained by reduced demand from mature UK defined-benefit pension funds or Bank of England gilt sales. A key underlying cause involves market doubts regarding long-term inflation and the credibility of the UK fiscal plan. Although UK debt and deficit ratios are less concerning than some G7 peers, this factor alone does not fully account for the premium.
The Labour conference in September is seen as a critical moment. Rachel Reeves highlighted the importance of rebuilding fiscal headroom and adhering to fiscal rules to reduce debt-interest spending. Since the conference, 10-year gilt yields have fallen by about 20 basis points, but there has been little change since last month's budget.
The Office for Budget Responsibility downgraded the growth outlook, and confusion surrounding budget communications has further undermined confidence. Market expectations indicate that the Bank of England may cut interest rates three times by the end of next year as inflation cools, potentially lowering mortgage rates. However, these gains depend on gilts becoming less punitive and the political risk premium diminishing.
Oxford Economics has warned that if growth remains fragile, markets could question the UK's fiscal credibility, which may lead to a steeper yield curve and a weaker sterling.
