UK borrowing costs hit highest since 1998, pound slides on fiscal worries

By Dhara Ranasinghe and William Schomberg

LONDON (Reuters) -Britain's 30-year borrowing costs rose to their highest levels since 1998 and sterling slid over 1.5% on Tuesday, highlighting growing investor anxiety about the UK's ability to keep its finances under control.

The selloff in British bonds, known as gilts, coincided with selling across major bond markets where the focus is firmly on rising debt levels.

But weakness in sterling - set for its biggest one-day fall since 2023 - pointed to vulnerability in UK markets at a time of increasing concern about the Labour government's ability to exercise fiscal constraint.

"The UK has had a perilous (fiscal) backdrop and that's going to continue," said Lloyds FX strategist Nick Kennedy.

"Over the summer, there has been a bit of a risk premium built into the rates market. Investors are now wanting more of a risk premium for sterling as well."

Thirty-year gilt yields rose to 5.697%, their highest since May 1998. Sterling was last down 1.1% at $1.34 and was 0.5% softer at 86.98 pence per euro - by far the weakest performing G10 currency against the dollar.

CHALLENGES AHEAD

The pressure on British assets came a day after Prime Minister Keir Starmer reshuffled his top team of advisers, moving finance minister Rachel Reeves's deputy Darren Jones into Downing Street to better coordinate delivery across government.

Starmer also appointed a former Bank of England deputy governor, Minouche Shafik, as his chief economic adviser, to bolster economic expertise ahead of what is expected to be a difficult budget later this year, but also sparking headlines that the move had weakened Reeves.

Analysts said the changes on the first day of parliament after the summer recess renewed focus on the economic challenges given heavy levels of borrowing, slow economic growth and the highest inflation rate in the G7.

Santander said it now expects the Bank of England to hold rates at 4% until end-2026, versus a previous call for two cuts next year.

With the budget unlikely to come before November, Britain faces weeks of speculation on tax rises, potentially dampening investment and consumer confidence.

"With each gilt ‘episode’ and subsequent rise in yields we are getting closer to the endgame where the government's options are running out," said BlueBay Asset Management fund manager Neil Mehta.

"The endgame could consist of the government reneging on manifesto commitments and possibly even the end of Starmer/Reeves, but ultimately the UK’s economic problems lie deep (energy, housing, labour) which could take a much longer time and bigger political shakeup."

In one reassuring sign, Britain sold a record 14 billion pounds ($18.9 billion) of new 10-year bonds on Tuesday, after attracting over 140 billion pounds in orders from investors.

And Britain is not the only country suffering fiscal worries.

France's 30-year government bond yields surged to their highest levels in over 16 years on Tuesday, driven by fiscal concerns and political instability. Japan's bonds have sold off heavily this year on concern about rising debt.

"You see long-end yields everywhere rise, but the UK does tend to perform the worst," said Lloyds' Kennedy.

(Reporting by Dhara Ranasinghe, William Schomberg and Jaspreet Kalra; additional reporting by Kate Holton and Yoruk Bahceli; editing by Alun John, Karin Strohecker and Mark Heinrich)