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A fall in borrowing costs has given UK chancellor Rachel Reeves greater room for manoeuvre as she tries to keep to her tight fiscal rules, but the public finances remain exposed to the country’s deteriorating economic outlook, analysts warn.
UK government bonds have erased the bulk of their losses since Reeves’ October Budget, bringing long-term borrowing costs close to the level they maintained before her tax and spending plans accelerated a gilt market sell-off.
Ten-year gilt yields, which move inversely to price, fell as low as 4.44 per cent on Friday, below last month’s 16-year high of 4.93 per cent and near the pre-Budget level of 4.32 per cent.
But grim forecasts this week from the Bank of England, which halved its 2025 growth estimate, suggest that the government will struggle to bring down borrowing rapidly in the coming years.
It “just goes to show how quickly the mood music changes”, said Nick Hayes, head of fixed income at Axa Investment Managers. “Not long ago gilts were in a ‘doom loop’ . . . and yields were heading to 5 per cent”.
The resurgence in gilts is due to a combination of a global bond rally and the prospect of faster interest rate cuts by the BoE, which announced a quarter-point reduction on Thursday, amid signs of flagging economic growth and easing inflation.
The market move has provided relief for Reeves as she attempts to keep to her self-imposed fiscal rule that day-to-day spending is covered by tax receipts.
The Office for Budget Responsibility, the UK’s fiscal watchdog, said in October that the chancellor had £9.9bn of headroom — the spare margin she has against meeting her fiscal rule.
The subsequent rise in gilt yields had led economists to warn that such a slender room for manoeuvre — the third-lowest since 2010 — had been wiped out by higher borrowing costs.
Andrew Goodwin at Oxford Economics estimates that because of the gilt market rally Reeves now has about £5bn in fiscal headroom, half October’s level, but better than the negative position in the depths of the January sell-off.
He warned however that the extra scope Reeves has gained “pales in comparison to what could happen if [the OBR] changes its growth or earnings forecasts”.
He added: “It was a very big risk to leave so little headroom to start with, and that risk has potentially crystallised.”
Many fund managers have a similar analysis and argue that further spending cuts or tax rises will be needed to bolster the UK’s fiscal position.
Economists say that if the OBR sets out a similar downbeat economic forecast to this week’s BoE estimates, it would add to pressure on public finances, because of lower growth in tax revenues.
The BoE now expects GDP will grow just 0.75 per cent this year, before picking up in 2026 and 2027, while unemployment could rise to 4.75 per cent.
It has also become more pessimistic about the rate at which the UK economy can grow without pushing up inflation.
In its annual stock take of the supply side of the economy, the central bank said the UK’s potential growth rate — often described as a “speed limit” on sustainable GDP growth — had slowed to just 0.75 per cent by the start of 2025, down from 1.5 per cent a year earlier.
The BoE said it expected potential growth to pick up in subsequent years, leaving its forecast at 1.5 per cent.
Huw Pill, BoE chief economist, said on Friday that the bank was “not in a situation where we can declare job done” when it comes to quelling inflation, as he insisted they would not be rushing to lower rates.
“There is still a need to maintain some restriction in the monetary policy stance,” he said, adding that higher than expected pay growth was a reason for caution when it came to further rate reductions.
Some economists have predicted the OBR may eventually be forced to reduce its forecast for potential growth given the persistently disappointing performance of UK productivity in recent years.
That would deal a serious blow to the public finances, since the OBR forecasts are the basis of the government’s budget plans.
A cut to potential growth predictions would have “really big impacts on Rachel Reeves’ headroom”, said Rob Wood at Pantheon Macroeconomics.
The chancellor will be “desperately hoping” the OBR does not decide to make such a downgrade, he added.
