The yield spread between UK and German government bonds recently reached a 34-year high, once again raising concerns about the UK's economic outlook. As of Wednesday, the UK's 10-year government bond yield rose by 4 basis points to 4.563%, while Germany's 10-year bond yield increased by less than 2 basis points to 2.256%, widening the spread to 230.7 basis points, a record since 1990. This level even surpasses the peak seen during the UK's "mini-budget crisis" in 2022.
Inflation Stickiness and Policy Pressure
The main driver behind this gap is the persistent high inflation in the UK. The latest data shows that the UK's Consumer Price Index (CPI) in November rose by 2.6% year-on-year, reaching an eight-month high, far exceeding the Bank of England's 2% target. Analysts point out that the inflation rebound is mainly driven by wage growth and rising domestic consumer prices. This phenomenon makes the market cautious about the Bank of England's future rate-cutting potential.
According to analysis by Jim Reid, a strategist at Deutsche Bank, the UK's inflation stickiness may be harder to alleviate than in the US and Eurozone, hence the Bank of England might not lower rates as aggressively as the Federal Reserve or the European Central Bank. Investors expect that by November 2025, the Bank of England's rate cuts will amount to only 53 basis points, further supporting the expectation that the Bank of England will maintain high rates.
Historical Context and Current Crisis
The current level of yield spread even surpasses that of the 2022 UK "mini-budget crisis." At that time, the UK government announced a large-scale tax cut plan without providing a clear fiscal spending scheme, sparking concerns over debt and fiscal sustainability, leading to soaring bond yields and a sharp depreciation of the pound, and causing a chain reaction in pension fund investment tools (LDI) resulting in historic market turmoil.
Nevertheless, economists point out that the current situation differs from the "mini-budget crisis." On October 31, the new Labour government released a budget that included a large-scale tax increase plan for businesses. Although the market reacted, its fiscal sustainability was not severely questioned.
Stagflation Risk and Economic Dilemma
The UK's inflation data has intensified market fears of "stagflation," an economic dilemma where high inflation and low growth coexist. High inflation poses greater pressure on the UK Prime Minister and central bank decision-makers, especially in a context of sluggish domestic economic growth. Analysts warn that this situation could further undermine confidence in the UK economy and have an impact on global investors.
Outlook
With UK inflation remaining high, the uncertainty of the interest rate path may continue to increase the risk premium. Although the market expects the Bank of England to keep rates unchanged in the short term, the ongoing presence of high inflation and stagflation risks will test the policy capabilities of the new Labour government. Meanwhile, the volatility of the UK bond market may become an important indicator of the health of the UK economy.
