Soaring borrowing costs have wiped as much as £10billion off Britain’s Budget headroom in just a week as the war in the Middle East plays havoc with public finances.
Bets that interest rates will stay higher for longer as a result of the crisis have prompted a sharp sell-off of UK bonds, known as gilts.
Investors are also anxious that surging oil and gas prices could result in a potentially costly bail-out to protect households from huge energy bills.
Yesterday, yields on ten-year gilts surged close to 4.8 per cent – a six-month high – before slipping back to just above 4.6 per cent.
Two-year gilts, which closely follow interest rate expectations, leapt above 4.2 per cent to their highest level in nearly a year before also coming down.
Sanjay Raja at Deutsche Bank said the latest market moves have shaved £7billion to £10billion from Rachel Reeves’ headroom.
Chancellor Rachel Reeves’ hopes about inflation and interest rates coming down were already out of date as the Iran conflict took hold – and the outlook has only worsened
It is a bitter blow to the Chancellor after she had seen ten-year yields gradually slope down to just over 4.2 per cent by the end of last month – the lowest since December 2024.
That had left Reeves able to boast in her Spring Statement last week of a modest increase to her ‘headroom’ against meeting fiscal targets – from £21.7billion at the time of last November’s Budget to £23.6billion.
She had also voiced optimism about inflation and interest rates falling.
But those hopes were already out of date as the Middle East conflict took hold. Just weeks ago, markets had expected the Bank of England to cut interest rates twice this year – starting next week.
Now, with rising oil and gas prices pushing inflation higher, hopes of a cut have evaporated, and some traders are even betting on a rate hike.
The gilt sell-off seen over the past week has mirrored similar trends across advanced economies.
But it has been more pronounced in the UK as the parlous state of public finances under Labour leaves them more vulnerable.
The prospect of an energy bail-out has added to these jitters.
Yesterday, Prime Minister Keir Starmer’s assertion that ‘supporting working people and their families with the cost of living is always top of my mind’ did little to dampen such speculation.
That could have uncomfortable echoes of Liz Truss’ time in office, when a huge bail-out spurred by the energy crisis at the start of the Ukraine war helped trigger a bond market sell-off.
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