The UK has paid the highest borrowing cost on two-year debt this century at an auction of £4bn of gilts, as the recent surge in bond yields feeds through to the government’s finances.
Gilt prices have slumped in the past few weeks, pushing yields sharply higher, as stubbornly high inflation stokes expectations that the Bank of England will have to raise interest rates much further to curb rising prices.
The sale on Wednesday of a gilt maturing in October 2025 priced at a yield of 5.668 per cent was the highest two-year borrowing cost since the UK Debt Management Office was established in 1998. It was also the highest yield on any debt sold by the UK government since 2007 when a five-year gilt was priced at a slightly higher yield.
When the bond was first issued in January this year the yield was 3.634 per cent.
“The elevated accepted yield of today’s auction is reflective of the feed-through of high market rates into higher government borrowing costs,” said Richard McGuire, a fixed income rates strategist at Rabobank.
The BoE surprised markets last month by lifting borrowing costs by 0.5 percentage points, more than most investors expected, piling more pressure on short-term gilts, which are highly sensitive to interest rate expectations. The unexpectedly forceful response has convinced investors that the BoE is likely to continue raising rates aggressively until there is a decisive shift lower in consumer price rises. Swaps markets are now pricing in that UK interest rates will peak at 6.25 per cent early next year.
Speaking at a European Central Bank conference in Sintra last week, BoE Governor Andrew Bailey said the bank would be “evidence-driven” in setting interest rates and that it was looking at both the peak of rates and “how long [the peak] sustains beyond that”.
The UK’s latest data showed that headline prices had risen 8.7 per cent in the year to May, with core inflation, which strips out volatile food and energy prices and is viewed as a better indication of underlying price pressure, accelerating ahead of expectations to 7.1 per cent.
The yield on the two-year bond issued at Wednesday’s auction was also at a significant premium to the UK’s current two-year benchmark debt, which at present yields 5.3 per cent in the secondary market.
Analysts said that bonds that have been issued since the BoE stopped hoovering up large chunks of UK debt under its quantitative easing programme — such as the gilt sold on Wednesday — are typically trading at larger yield premiums owing to less competition to buy the bonds.
“It’s been a bit of a phenomenon since the start of 2022 — bonds which are being actively supplied by the Debt Management Office are trading at quite a big discount relative to the surrounding bonds,” said Megum Muhic, a strategist at RBC Capital Markets.
Pressure on the UK government’s borrowing costs comes as it plans to sell £241bn of gilts in the current financial year, a sharp increase from £139.2bn issued in the last financial year, with issuance net of BoE purchases expected to be about three times more than the average over the past decade.