UK borrowing costs soar as Iran ceasefire collapses
The UK’s borrowing costs have sailed past five per cent for only the third time since the onset of the Iran war, in a headache for Andy Burnham just days before he enters Downing Street.
The yield on the UK’s 10-year government bond – the benchmark for a country’s long-term ability to borrow – climbed by as much as seven basis points on Tuesday morning, after the fragile ceasefire between Iran and the US shattered.
The two countries exchanged strikes for a third successive night, in a dramatic escalation of tensions that has seen oil prices surge back to levels not seen since the middle of June. The increasing likelihood of a return to all-out conflict caused Brent crude to jump more than nine per cent in a single session on Monday – its biggest daily gain since May 2020.
The US military carried out another offensive on Iranian military sites, which the country’s military command said would “continue imposing a heavy cost on Iranian forces and degrade their ability to attack… commercial shipping”. Donald Trump also reinstated the US blockade of Iranian ships in the the Strait of Hormuz, while the UAE reported two tankers being struck by Iranian missiles.
Government bond yields surged across developed economies as a result, with the 10-year US Treasury yield climbing more more than five basis points over Monday.
UK borrowing costs exposed by Iran war
The sell-off has been particularly pronounced in the UK, where borrowing costs have proven especially exposed to developments in the war due to the country’s heavy reliance on imported energy and stubborn underlying inflation.
Higher inflation tends to force traders to require a higher interest rate for holding bonds, because higher prices in an economy threaten to eat into bondholders real returns. Investors also price in central bank interest rates remaining higher for longer when price rises are stubborn.
“Since the start of the Iran War, UK gilts have been especially volatile and the last couple of days have seen outsized movements in UK gilts,” said Daniel Mahoney, senior UK economist at Handelsbanken.
“We expect UK gilt yields to remain the highest in the G7 – and there could be some further market response to the incoming Prime Minister’s selection for Chancellor.”
The sell-off also played out in Britain’s shorter-dated bonds, which tend to track interest rate expectations more closely. The yield above the two-year gilt climbed 10 basis points to trade above 4.5 per cent for the first time since mid-May, as traders ramped up bets that the Bank of England could raise its central interest rate at its next meeting on 30 July.
The sharp rise in borrowing costs pose a major fiscal challenge to Andy Burnham just days before the former Manchester mayor is due officially to become Prime Minister. The 60-day ceasefire agreed between the US and Iran in June had helped ease pressure on the public finances in recent weeks, with the 10-year bond yield falling by more than half a percentage point from its peak in May.
“The energy price spike means that the market is also rushing to price in more interest rate hikes,” said Kathleen Brooks, research director at XTB. “There is now a full hike priced in from the Bank of England by year end.”
The market also expects the Federal Reserve to raise interest rates rates this year, with markets implying a 40 per cent chance that the rate-setting Federal Reserve Open Markets Committee will opt to hike when they meet this month.