Britain’s Fragile Fiscal Balance: An Investor’s Perspective

The Fragility of Confidence in the UK Economy

On 13 January 2025, the spread between 10-year UK gilts and German Bunds hit 230 basis points—a concerning peak not seen since the turbulence of Liz Truss’s premiership in 2022. While a borrowing crisis seems unlikely, the situation underscores the precariousness of the UK’s fiscal and monetary outlook. For policymakers, retaining the confidence of creditors and investors is paramount.

Rising Yields: A Comparative Lens

Since January 2021, interest rates have surged across the G7, driven by normalisation of monetary policy and inflationary pressures. However, the UK stands out with an outsized increase of 440 basis points in its 30-year gilt yields. By mid-January, these yields reached 5.2%, the highest among G7 economies, surpassing Germany (2.8%) and France (3.9%), and even eclipsing Italy by 56 basis points.

The divergence is particularly alarming when compared to Italy, a country traditionally seen as fiscally weaker. Italy’s yields remained stable over the past year, while UK gilt yields rose by 78 basis points. This disparity highlights the UK’s struggle to align itself with the financial stability of its peers.

The Role of Real Rates

The UK’s rising yields are primarily driven by real interest rates, not inflation expectations. Real rates have climbed sharply from a trough of -3.4% in December 2021 to 1.3% in January 2025, indicating a significant shift from an era of ultra-low borrowing costs. While this adjustment reflects global trends, the magnitude of the increase in the UK exposes vulnerabilities, particularly given its high debt-to-GDP ratio and reliance on foreign capital.

Debt Sustainability: A Delicate Balancing Act

To stabilise the debt-to-GDP ratio, governments must maintain primary fiscal surpluses when real interest rates exceed economic growth. The UK’s real interest rate of 1.3% aligns closely with its historical growth rate. Encouragingly, the Office for Budget Responsibility (OBR) projects primary fiscal surpluses of around 1% of GDP by the decade's end, suggesting a path toward debt stabilisation. However, this outlook hinges on consistent GDP growth and disciplined fiscal policy.

Risks on the Horizon

Despite manageable forecasts, risks loom large:

1. Global Interest Rates: Further increases in global rates—due to heightened defence spending or escalating geopolitical risks—could exacerbate borrowing costs.

2. Low Growth: The UK’s sluggish GDP growth is a critical vulnerability. A further slowdown could undermine fiscal targets and investor confidence.

3. Capital Dependence: Persistent capital account surpluses make the UK heavily reliant on foreign funding, a structural weakness exacerbated by its departure from the EU.

4. Debt Levels: The UK’s debt-to-GDP ratio, approaching 100%, is high compared to historical levels, though lower than Italy, France, and Japan.

Additionally, political uncertainties, including the risk of protectionist policies from major trading partners, add to the fragility.

Navigating a Post-Cheap Borrowing Era

The era of ultra-low interest rates is over, necessitating a recalibration of policy. The UK government must demonstrate fiscal discipline through carefully calibrated tax policies and controlled public spending. Ill-conceived regulatory interventions, particularly in the labour market, risk further eroding investor confidence.

MY OPINION: Prioritising Resilience and Growth

While panic is unwarranted, complacency is not an option. The UK needs a dual focus: bolstering economic resilience and reigniting growth. A proactive approach to productivity—through investments in infrastructure, innovation, and education—could mitigate long-term risks. Additionally, fostering international trade partnerships post-Brexit is essential to offset vulnerabilities linked to foreign capital dependence.

From an investor’s perspective, UK gilts remain a complex proposition. While yields are attractive, the associated risks demand careful consideration. Diversification across more stable markets, such as Germany and France, may provide a prudent hedge against UK-specific fragilities.

In conclusion, Britain’s fiscal and monetary position is at a crossroads. Ensuring stability will require not just sound policy but the confidence of global markets. The government’s next moves will be pivotal in determining whether the UK’s fiscal story is one of resilience—or regret.