As 2024 draws to a close, fears of stagflation are stirring volatility in the UK gilt market. Recent data shows UK GDP shrank for a second consecutive month in October, while inflation remains stubbornly high. As a result, UK borrowing costs have surged, with the spread between UK and German 10-year bond yields reaching its highest level since the early 1990s.

The numbers tell the story. Ten-year gilt yields have risen to 4.58%, up from less than 4.2% just two weeks ago. This resurgence recalls the market turmoil following October’s Budget and Liz Truss’s “mini-Budget.” Investors are now rethinking Bank of England rate cut expectations for 2025, with forecasts shifting from four cuts to two.

Why is this happening?

Stubborn Inflation: Services price growth hit 5% in November, exceeding the BoE’s 4.9% forecast. This signals deeper domestic inflationary pressures, particularly in the services sector, where wage growth remains strong.

Weak Growth: UK GDP has shrunk for two straight months, with October’s contraction surprising many. This raises concerns about future tax receipts and government borrowing sustainability.

Government Borrowing Plans: The Labour government’s borrowing plans have left investors uneasy. Higher borrowing could amplify debt concerns, while new fiscal measures are forecast to add 0.75 percentage points to GDP and 0.5 percentage points to inflation over the next year.

Broader Market Movements: UK yields are following a broader sell-off in US Treasuries, with market sentiment shifting since Donald Trump’s election win. Rising US yields tend to push up UK and European yields.

So, where does this leave us?

Investors are bracing for a more prolonged period of higher interest rates. The BoE’s upcoming policy meeting will be pivotal. Will they maintain their hawkish stance to combat inflation, or will weak growth force their hand? For now, it’s the former.

The implications are broad. Rising gilt yields mean higher borrowing costs for the UK government. With fiscal policy already stretched, Chancellor Rachel Reeves faces tough decisions. She may need to revisit tax and spending commitments if markets demand stronger assurances on debt sustainability.

For policymakers, stagflation poses a unique challenge. Unlike inflationary shocks, which can be tackled with rate hikes, stagflation’s dual threats of slow growth and rising prices are much harder to manage.

This story is still unfolding. Today’s BoE meeting will be closely watched. Will the Bank’s strategy shift, or will their resolve to combat inflation remain firm? Either way, 2024 is ending with a clear message—there are no easy options for central bankers, policymakers, or investors alike.

Thanks to Ian Smith and Sam Fleming at the Financial Times

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