The increase in UK borrowing costs brings up the possibility of reducing public spending.

• Since the Labour government unveiled its first budget plan in October, the march higher in U.K. government bond yields has raised concerns, as borrowing costs have surpassed numerous decade highs.
• According to economists at research group Capital Economics, gilts may be caught in a "vicious cycle," where an increase in U.K. yields puts pressure on public finances, necessitating a tighter fiscal policy, but this, in turn, puts additional strain on the economy.

Since the launch of the Labour government's debut budget plan in October, borrowing costs have risen to breach numerous decade highs, causing widespread concern in the U.K. government bond yields.

The possibility of public spending cuts or additional taxes emerged as yields reached their highest level since 1998. Although yields initially decreased after Labour's election victory in July, they have since risen above 4.5%, and the 10-year yield has reached levels not seen since 2008.

The decline in investor confidence in the U.K. was emphasized by the simultaneous drop in sterling, which reached its lowest point against the U.S. dollar since November 2023 on Friday.

The return of Donald Trump to the White House and expectations for broadly higher interest rates than previously expected this year are weighing on the U.K. Additionally, borrowing costs are also rising in the euro area and the U.S.

The surge in U.K. yields is a significant challenge for the U.K. government, which aims to revive economic growth while reducing public sector net debt as a percentage of GDP within five years. Currently, the U.K.'s public sector net debt is almost 100% of GDP.

According to ING Senior European Rates Strategist Michiel Tukker, in a Friday note, the increase in gilt yields has a self-reinforcing feedback loop through the U.K.'s debt sustainability, as it leads to higher borrowing costs used for budgeting purposes.

According to analysis by the independent Office of Budget Responsibility, if the recent increase in yields continues, it will eliminate the government's estimated budget surplus of £9.9 billion ($12.1 billion) for meeting its fiscal rules. Additionally, these rules require Labour to reduce the U.K.'s debt to GDP ratio over the long term and cover daily government spending with revenue.

The Institute for Fiscal Studies think tank stated on Friday that there is a "knife edge" possibility of the U.K. meeting its fiscal rule, but that Finance Minister Rachel Reeves may have some luck.

Ben Zaranko, IFS Associate Director, stated that she faces an "unenviable set of options," including introducing changes to debt calculation, reducing current spending plans, announcing tax rises, or taking no action and breaking her rule.

According to economists Ruth Gregory and Hubert de Barochez at research group Capital Economics, the rise in U.K. yields is putting a strain on public finances, requiring an even bigger tightening of fiscal policy. However, this tightening is putting additional strain on the economy, creating a "vicious circle" for U.K. gilts.

According to Bank of America Global Research strategists, it is unlikely that Labour will break its rules and instead, they predict that the party will announce further fiscal consolidation measures, such as public debt reduction or spending cuts or tax increases, in the spring or earlier.

The £40 billion in tax hikes announced by Labour in October may have led to spending cuts, according to some.

CNBC has contacted the Treasury for comment.

UK in 'slow growth trap' — but not a mini-budget crisis

On Friday, Vince Cable, the former U.K. Finance Minister, stated on CNBC that many countries were experiencing higher bond yields, which was not an "emergency panic situation." However, he added that markets had come to the realization that Britain was trapped in a "slow growth pattern."

Since the Financial Crisis, Brexit, Covid, and Ukraine war, the U.K. has faced challenges such as high inflation and slow growth, leading to a decline in the markets. However, this is not a crisis situation or a panic sell-off, as Cable stated.

Instead of focusing solely on raising National Insurance, Labour should have considered a broader range of tax increases, which has been criticized by the U.K. business community. Nevertheless, Cable acknowledged that the market has broader concerns about U.K. growth and the global economic climate, which is influenced by external factors such as the weaker Chinese outlook.

Liz Truss's announcement of sweeping tax cuts in 2022 caused massive volatility in the bond market, but Cable downplayed comparisons with the U.K. mini-budget crisis.

Cable stated on CNBC that the Truss moment was a prime minister taking a reckless leap into the dark with a big increase in the budget deficit, assuming it would trigger economic growth. However, it is clear that this assumption did not hold true this time. The argument now revolves around whether enough tightening has been done and whether it has been done in the right way, but it is a different kind of problem.

The sentiment that the Bank of England's intervention in the gilt market was necessary was not widely shared in analysis. Bank of America strategists argued that comparisons with the mini-budget were exaggerated, and that the bar for intervention was set high.

Capital Economics stated that last week's higher gilt yields were a minor setback, with smaller and slower movements compared to after the mini-budget. Meanwhile, David Brooks, head of policy at Broadstone, noted that there were no "systemic issues" in the LDI funds that were the main concern in 2022.