The UK’s government continues to grapple with escalating borrowing costs. Since the general election last year, despite four interest rate cuts from the Bank of England, the yield on ten-year UK gilts has increased from 4.2% to 4.6%. Extending the borrowing period to 30 years reveals a rise from 4.7% to 5.4%. This surge contributes to annual debt servicing expenses of £105 billion, nearly equivalent to the entire public sector investment budget soon to be announced by Rachel Reeves during her first spending review as chancellor.

While the increasing expenses of public sector debt are concerning, interpreting the implications of these interest rate fluctuations is equally challenging. Economists, bond investors, and politicians fiercely debate these interpretations. The outcome will influence fiscal policies regarding healthcare, defense, education, pensions, and taxes for years to come. This situation, often referred to as the “$64,000 question,” has escalated into a £2.5 trillion dilemma for the UK due to rising inflation and substantial debt accumulation in the past twenty years.

Some analysts argue that we are witnessing a normalization of interest rates after an extended period of near-zero rates, a result of £36 trillion worth of central bank debt purchases and robust demand from pension funds needing debt to address their liabilities. The financial landscape, following the 2008 global financial crisis, experienced unprecedented low-interest rates.

Government debt was sought after extensively, causing various UK and international interest rates to stabilize around zero. However, this trend has reversed, and interest rates have climbed back to levels last observed in the late 1990s. Many investors express surprise that rates are not even higher, considering the current global indebtedness of £325 trillion. Should this view of normalization persist, it could be seen as a beneficial shift, potentially leading to more responsible budgeting, fewer inflated asset bubbles, particularly in real estate, and a diminished need for high-risk investment strategies.

This optimistic scenario might contrast with historical economic patterns. Economist Hyman Minsky warned that long periods of financial stability could foster instability. The term “Minsky moment” aptly describes the leveraged liability-driven investment (LDI) crisis that led to the fall of Liz Truss’s government in 2022, as pension funds engaged in high-risk LDI strategies amidst an environment of low-interest rates.

It is overly simplistic to assume that other, more subtle Minsky moments will not arise. For instance, the U.S. hedge fund sector almost experienced a similar situation back in April following President Trump’s “liberation day.”

A more alarming interpretation suggests that investors may lack faith in the political framework necessary for sustainable debt management, unless accompanied by persistently higher inflation or a debt default scenario. A frustrating aspect of UK economic dialogues is the emphasis on short-term perspectives concerning the nation’s debt and deficit dynamics. Although UK public sector debt equals 100% of GDP, projections indicate it could skyrocket to an astonishing 270% of GDP by 2075, according to the Office for Budget Responsibility.

Lenders looking at long-term UK government bonds are not particularly concerned about short-term welfare measures like means-testing winter fuel payments or imposing caps on child benefits. Instead, they focus on the viability of the triple-lock state pension, defined benefit public sector pensions, a National Health Service (NHS) that is free at the point of use, and a social care system lacking a long-term funding strategy.

Maintaining these commitments while the population of Britons aged over 80 is expected to double to 7 million seems increasingly untenable.

When bond investors consider the procrastination surrounding essential social care reviews, the ambitious pledge to elevate defense spending to 3% of GDP without clear funding plans, and the rise of Reform UK, a party gaining momentum in opinion polls yet presenting numerous uncosted proposals, the conclusion becomes evident: interest rates must rise to compensate for the impending surge in debt issuance.

A global context also plays a role in this dynamic. UK assets, including government debt, must vie for investor attention alongside offerings from around the world. As previously noted, Japan is currently providing interest rates not seen in decades, and the Trump administration has made capital repatriation to the U.S. a policy priority. Recent UK pension reforms, aiming to encourage asset managers to invest more in UK private assets, signify an acknowledgment that the British economy has become an unappealing destination for capital investments for too long.

This situation provides crucial insight into how bonds market signals should be interpreted. Investors still view the UK as an appealing but costly venue for capital investment. Factors contributing to this perception include the UK having the highest energy costs among industrialized nations, as well as rising expenses related to high-speed rail, nuclear power, and lengthy approval times for both residential and commercial property developments—all attributed to regulatory frameworks established during a low-interest-rate environment. These continued high costs could only be managed by pushing tax levels even higher, reaching a 75-year peak.

For UK government debt to avoid becoming the outlier in the global bond market and to keep interest rates from escalating further, it must effectively communicate to investors an affirmative message to builders, innovators, and entrepreneurs: “Yes, you can.” So far, this message has been conveyed only quietly. To prevent entering a cycle of debt, taxes, and austerity, a more vocal commitment to this declaration is essential.

Simon French is the Managing Director, Chief Economist, and Head of Research at Panmure Liberum.