Global Investment Strategy | Global Financial Services

The UK now holds the uncomfortable distinction of having the highest long-term borrowing costs among G7 nations. Last week, 30-year gilt yields nudged above 5.6%, levels not seen since 1998. Even the 10-year gilt yield, the market's benchmark, remains the highest in the group, signalling deeper structural and cyclical concerns.

For institutional investors and macro watchers alike, this persistent yield elevation isn’t just about inflation - it's about credibility, supply-demand mismatches, and a stubborn “risk premium” the UK just can’t shake.

Inflation: Sticky, stubborn, and still in charge

Despite the Bank of England’s best efforts, UK inflation continues to outpace that of the Eurozone, pushing expectations for interest rate cuts further into the future. With CPI hovering near 4%, markets have priced in only one modest rate cut before the end of 2025, compared to five for the US and an already halved rate from the ECB.

This “higher-for-longer” rate stance keeps short-term gilt yields elevated, but it doesn’t fully explain the surge in long-term borrowing costs. Interestingly, long-term inflation expectations have actually declined in recent months, which suggest more profound market anxieties beyond the headline CPI.

The steepening curve: Supply, demand, and the return of the risk premium

What’s driving the steepness in the UK yield curve if inflation isn't the long-term culprit?

The answer lies in the confluence of global and domestic forces. First, sovereign debt issuance has increased significantly. Across the OECD, governments are expected to issue a staggering $17 trillion in debt in 2025 alone, up from $14 trillion in 2024. In this crowded landscape, UK gilts must compete for capital against US Treasuries, German Bunds, and Japanese government bonds.

However, the UK also faces some unique headwinds. Ever since the 2022 mini-budget crisis under Liz Truss, UK gilts have carried a reputational overhang, though that perception is gradually fading. And while the political climate has stabilised under Rachel Reeves, her decision to increase borrowing has left only a narrow margin under existing fiscal rules - something which has not gone unnoticed by the bond market.

Investors are demanding a "risk premium" for holding long-term UK debt, not because they fear default, but due to uncertainties surrounding fiscal discipline and future issuance volumes. Simply put, investors are demanding a premium for perceived fiscal uncertainty, even if outright fragility is not the consensus view.

Pension funds exit, the BoE sells, and supply keeps surging

Those who follow the cost of borrowing in the UK will appreciate that the demand-side dynamics are compounding the issue. Defined benefit pension schemes - once reliable buyers of long-dated gilts - are gradually winding down. At the same time, the Bank of England is actively unwinding its balance sheet, selling gilts into a market already saturated with new supply. Consequently, the UK Debt Management Office has come under pressure to adjust the maturity profile of its issuance strategy to reduce long-end stress; however, the damage is already visible.

This imbalance is so stark that 10-year gilt yields have begun trading above equivalent interest rate swaps. This is an inversion of typical norms, indicating investor discomfort with gilts specifically, rather than with rates broadly. In Germany and elsewhere, similar “negative swap spreads” reflect temporary market distortions. In the UK, they look increasingly structural.

Will autumn’s budget calm the market or ignite it?

Looking ahead, all eyes are on Rachel Reeves’ Autumn Budget with rumours and counter-rumours already swirling around financial markets. While sterling has stabilised and 10-year yields have been less volatile than their 30-year counterparts, the pressure is mounting. Most analysts expect Reeves to stay within her fiscal limits, likely by raising taxes or trimming spending, but the bond market is watching closely. There’s little (if any) margin for error.

A perceived backtrack on fiscal tightening, or worse, the avoidance of core tax increases, could trigger another sharp sell-off in gilts. As Craig Inches of Royal London Asset Management warns, a reluctance to raise core taxes could ‘push the self-destruct button for the long end of the gilt market’.

Conclusion: A delicate dance between policy and perception

The UK’s elevated borrowing costs reflect more than just inflation; they are a referendum on fiscal credibility, monetary coordination, and investor trust. As global capital becomes more discerning, the UK must work harder to retain its share. The BoE’s hands are tied by inflation; Reeves’ options are limited by political and fiscal constraints. In that gap, the yield curve steepens, and investors price in risk.

The gilt market doesn’t need panic to unravel; it just needs doubt. And right now, there’s still plenty of that to go around.

Investor takeaway

Until inflation cools decisively and fiscal signals turn clearer, UK gilts are likely to carry a structural premium. For fixed income strategists, that presents both risk and opportunity, but only for those who price in not just the numbers, but the narrative.