What Might the Government’s Fiscal Woes Mean for Investors in UK Gilts?

Recent developments have revived doubts about the sustainability of the UK’s public finances. The government has been forced to abandon planned cuts to disability benefits following internal party opposition, while recent reports from the Office for Budget Responsibility (OBR) have warned of escalating long-term debt risks and acknowledged persistent overestimation of medium-term growth prospects. 

Pressure on the UK’s public finances is mounting amid weak economic growth, elevated debt servicing costs, and long-term structural challenges posed by an ageing population and the green transition. However, the debacle over benefits cuts has highlighted the growing tension between the need for fiscal discipline and the constraints of political reality. In this month’s commentary, we look at what recent developments might mean for investors in UK Gilts. 

Tough decisions postponed

Although the proposed changes to disability benefit eligibility would have delivered only modest savings, the government’s failure to implement them has cast doubt on its ability to pass contentious legislation, even with a large parliamentary majority. The aborted cuts, worth around £5 billion by 2029[1], are small relative to the UK’s estimated £152 billion deficit last year (5.3% of GDP[2]). However, this latest U-turn - following the earlier reversal on winter fuel payments - further erodes Chancellor Rachel Reeves’ £9.9 billion of fiscal headroom[3], narrowing the margin she has to meet her fiscal rule of balancing the current budget by 2029/30.

Moreover, with the economy contracting by 0.1% in May[4] and the OBR acknowledging that its medium-term growth forecasts have been consistently over-optimistic[5], there is a risk that the budget watchdog will downgrade its growth projections ahead of the autumn budget. This would further reduce the Chancellor’s fiscal room for manoeuvre. Taking these factors into account, the shortfall in the public finances could exceed £20 billion[6].

Fiscal discipline and the Gilt market

In turn, this raises the prospect of further spending cuts, tax hikes or a relaxation of the fiscal rules to allow more borrowing. With a recent spending review completed and a return to austerity ruled out, further departmental cuts would be politically difficult. For UK Gilt investors, the greatest concern is the potential relaxation of the fiscal rules and the prospect of increased debt issuance. Chancellor Reeves is seen by markets as fiscally disciplined and has said that the fiscal rules - requiring the current budget to be on track for balance or surplus by 2029/30 and for public sector net debt to fall as a share of GDP by the same year - are non-negotiable.

The Chancellor’s pivotal role in maintaining market confidence was underscored on 2nd July, when speculation over Reeves’ future drove a 20-basis point spike in the 10-year Gilt yield - the largest one-day move since October 2022[7] - before yields retreated following Downing Street’s reassurance that she was “going nowhere.”

Reeves’ association with the proposed cuts to winter fuel allowance and disability benefits - both later reversed - has left her vulnerable. However, the bond market’s sharp reaction to speculation about her departure, and the prospect of a more spendthrift successor, suggests that Prime Minister Keir Starmer will be wary of sacking her.

Debt rises despite fiscal rules

Even if there is no formal relaxation of fiscal rules, the UK’s fiscal outlook is likely to keep the bond market on edge. The OBR’s recent Fiscal Risks and Sustainability Report warned of the ‘daunting’ risks to the UK’s public finances and noted that efforts to put the UK’s public finances on a more sustainable footing have met with only limited and temporary success in recent years[8] - a point underscored by the government’s recent U-turns.

Moreover, even with self-imposed fiscal rules in place, the UK’s debt pile has continued to rise. The OBR notes that although a falling debt-to-GDP ratio has been a feature of eight out of nine UK fiscal frameworks since 2010, underlying public debt has actually increased by 24% of GDP over the past 15 years[9]. The UK debt burden has risen since 2010 due not only to major shocks like Covid and the energy crisis - where government support was relatively generous - but also because post-crisis plans to consolidate the public finances were reversed, with tax rises scrapped, spending cuts abandoned, and fiscal rules repeatedly relaxed. As a result, the OBR notes that in 2024, the UK had the fifth-highest budget deficit among 36 advanced economies. Going forward, the OBR projects that, under current policies, demographic pressures will drive the public debt above 270% of GDP by the early 2070s[10].

Elevated yields

Against this backdrop, investors are likely to continue to demand a premium for investing in UK Gilts, particularly in long-term bonds where the fiscal outlook plays a greater role in driving yields. Various global factors have put upward pressure on global bond yields in recent months (see our commentary of June 2025[11]). However, the yield on the 10-year UK Gilt of 4.42% is currently 20 basis points higher than the equivalent US yield, and 170 basis points above that in Germany[12].

What’s more, concerns over the fiscal outlook have been a contributing factor to the relative steepness of the UK yield curve (i.e. the difference between short-term and long-term yields). The gap between the yield on the UK 10-year Gilt and that on the 2-year bond stands at nearly 80 basis points, its highest in four years[13].

Elevated bond yields increase debt servicing costs and dampen growth, raising the risk of a debt spiral, where rising borrowing costs force a government to take on ever more debt just to service existing obligations, leading to unsustainable fiscal dynamics. The UK’s debt interest costs are projected to total £111.2 billion in 2025-26, i.e. 8.3% of total public spending, or 3.7% of GDP[14]. The OBR notes that the effective interest rate on government debt now exceeds the economy’s likely nominal growth rate, which means that a higher primary budget balance (i.e. taxation revenues minus non-interest spending) is needed to stabilise the debt/GDP ratio. However, achieving this will mean shifting from a primary deficit of 1.9% of GDP[15] in 2024/25 to a surplus of 1.3%[16] - a politically challenging adjustment that would probably require further spending cuts and/or tax increases, potentially exacerbating the drag on growth.

Growth to the rescue?

Boosting economic growth, a goal that has been central to the government’s policy agenda, would undoubtedly improve the outlook for the public finances, but the omens on this front have not been good. Chancellor Reeves had promised that a period of political stability after 14 years of Tory ‘chaos’ would unlock growth in the economy. However, recent policy U-turns and expectations of further tax hikes have resulted in increased uncertainty, which was already high due to President Trump’s tariff policies. Progress regarding structural reform during the government’s first year in office has been limited, and many initiatives will only bear fruit over the longer-term.

The government’s flagship planning bill, designed to accelerate the approval and delivery of housing and major infrastructure projects by streamlining the planning system, is currently still being debated in parliament. However, the government’s recent decision to block construction of a major film and TV studio complex in Berkshire has once again cast doubt on its willingness to make difficult pro-growth decisions in the face of strong opposition.

More immediately, Rachel Reeves’ decision to increase employers’ National Insurance contributions in April is weighing on confidence and dampening demand for labour. The number of job vacancies has fallen to its lowest level since 2021[17], and survey data for June suggests that permanent job placements fell at their fastest pace in 22 months[18].

In turn, lacklustre growth and a cooling labour market are boosting expectations for interest rate cuts from the Bank of England (BoE). In a recent interview with The Times, Governor Andrew Bailey indicated that the BoE was prepared to make larger interest rate cuts if the labour market shows further signs of slowing down and creates more slack in the economy[19].

Implications for Gilts

While interest rate cuts should offer some near-term support, investors in UK Gilts must also weigh the longer-term risks posed by the state of the public finances and broader macroeconomic pressures.

For a country that issues debt in its own currency, the risk of outright default is minimal. However, persistent concerns over the sustainability of the UK’s public finances, and the difficulty in addressing the issues that are driving debt higher, mean that investors are likely to continue to demand a premium for holding long-dated Gilts. Holders of long-term Gilts face the risk that increased bond issuance will drive yields higher over time, and that political pressure could lead the Bank of England to tolerate higher inflation as a way to erode the real value of the debt.

If inflation averages 2% over the coming decade, the current nominal yield of 4.4% on a 10-year Gilt implies a real return of over 2% if the bond is held to maturity – a moderately attractive outcome. However, investors should be mindful that any rise in yields before the bond matures - whether driven by inflation or debt concerns - will lead to mark-to-market losses.

Shorter-maturity bonds, whose yields are more closely tied to the future path of official interest rates, carry a lower risk in this regard. Indeed, if Chancellor Reeves is forced to raise taxes again in the autumn budget to comply with the fiscal rules, and this triggers further downgrades to growth forecasts, it could prompt the Bank of England to cut interest rates more aggressively. In turn, if interest rates fall more sharply than is currently expected by the Gilt market, the front end of the yield curve could see mark-to-market price gains.

With growth risks skewed to the downside and worries about UK debt sustainability likely to increase if the Reform Party (which has promised large tax giveaways) make further gains in the polls, the yield curve is likely to remain relatively steep. Concerns over the fiscal outlook look set to keep the long end of the Gilt curve under pressure, even as rate cuts anchor the front end.

14^th July 2025