Turbulent UK Economy: Interest Rates, Bonds, and Currency Decline

Rising UK inflation and fiscal policy uncertainty, combined with a stronger-than-expected US labour market report, continue to exert pressure on UK government bonds and the pound sterling (GBP). The yield on 10-year UK government bond gilts recently reached 4.85%, nearing the peak last seen during the 2008 financial crisis, while the pound has weakened to its lowest level since November 2023.

The negative sentiment surrounding GBP, alongside a strengthening U.S. dollar (USD), also pushed the GBP/USD currency pair lower on Monday.

The relationship between interest rates and bond prices is clear: as rates rise, bond prices fall, and investors seek higher returns on newly issued securities. This dynamic particularly impacts countries like the UK, where high borrowing needs and limited fiscal flexibility exacerbate market pressures.

UK Chancellor Rachel Reeves now faces difficult decisions to manage the shrinking fiscal space. Oliver Faizallah, Head of Fixed Income Research at wealth manager Charles Stanley, highlights potential changes to government spending plans. “With poor growth figures, the Labour government may be forced to cut spending, raise taxes, or increase borrowing,” he says.

Despite similarities to the 2022 gilt crisis—when Liz Truss resigned as Prime Minister after just 51 days in office—many argue the current situation is less severe. Unlike 2022, when UK government policies directly triggered a bond market crisis, today’s downturn is more closely tied to global macroeconomic factors, such as US monetary policy.

Gordon Shannon, Portfolio Manager at TwentyFour Asset Management, emphasises the need for Reeves to demonstrate an understanding of the more challenging global environment by curbing spending. “We are waiting for the pound to weaken enough to make UK government bonds attractive to international investors,” he adds.

Katie Martin, Markets Columnist at the Financial Times, suggests this could happen “when 10-year gilt yields approach 5%”.

Regardless, it is evident that confidence-boosting measures from the government and favourable global market conditions are essential for recovery. This week’s upcoming UK inflation and GDP data release will provide further insights.

In summary, many analysts anticipate continued pressure on GBP/USD in the short term, particularly if the US economy remains resilient and inflation concerns persist. Technical indicators suggest that if the pair falls below 1.20, further declines toward 1.18 or lower are possible. However, positive economic signals from the UK or shifts in market risk appetite could spark a recovery for the pound.