The UK's borrowing costs are once again on the rise, and this time, it's not just about inflation. The recent conflict in Iran has sent shockwaves through the financial markets, with investors growing increasingly anxious about the potential impact on global growth. But here's where it gets controversial: while the government had hoped for a downward trend in borrowing costs, the unexpected turn of events has thrown a wrench in their plans.
The UK's improved borrowing position, announced in the spring statement, has been overshadowed by the Middle East crisis. Higher energy prices, driven by the conflict, are now feeding through to inflation, increasing borrowing costs further. This puts serious pressure on the budget outlook, and it's not just the government that's feeling the heat. Businesses and households, still recovering from a long period of elevated inflation, are now facing even more uncertainty.
The Bank of England's monetary policy committee held rates at 3.75% last month, after a majority of policymakers said they wanted to wait and see how quickly inflation would fall before making further reductions. But with the conflict in Iran showing no signs of abating, the market bets for interest rate cuts have fallen from 80% to just 30%.
The government had hoped that last month's decline in inflation to 3% and a faster fall in Whitehall's annual spending deficit would further push down the interest on UK debt. However, the better-than-expected borrowing figures trumpeted by Rachel Reeves in her spring forecast speech on Tuesday failed to generate a positive bounce amid growing anxiety over the Middle East crisis.
The yields on two-year gilts, effectively the interest rate, jumped as much as 16 basis points to 3.8% on Tuesday, although they later eased back to settle at nearer 10 points up. This is not just a blip, as the bond market is now pricing in the worst-case scenario of a prolonged war in the Middle East and an energy-price inflation shock.
So, what does this mean for the UK economy? Well, it's not just about the immediate impact on borrowing costs. The conflict in Iran could have long-term consequences for global growth, and the UK is not immune to that. As David Miles, the forecaster's chief economist, said, the predictions that inflation would fall to target levels early this year have become 'more uncertain' after jumps in oil and gas prices linked to recent attacks in the Middle East.
The UK plans to issue £252.1bn of government bonds in the 2026-27 financial year, according to the UK Debt Management Office. This compares with primary dealers' median forecast of £245bn of gilt issuance in a Reuters poll, down from £303.7bn of issuance in 2025-26. So, while the government had hoped for a more stable borrowing environment, the conflict in Iran has thrown a spanner in the works, and it's not clear how long it will take to get things back on track.
