UK Fiscal Credibility in Crisis: Why Gilt Yields Signal a New Era of Risk

The UK's fiscal credibility has been dealt a severe blow as markets increasingly doubt the government's ability to stabilize debt and adhere to its economic targets. The Office for Budget Responsibility's (OBR) admission of optimism bias in its forecasts—highlighting flawed productivity assumptions, delayed policy implementation, and fragile fiscal buffers—has fueled skepticism. This erosion of trust has translated into soaring gilt yields, a widening debt burden, and a loss of confidence in sterling. For investors, the writing is on the wall: the UK's fiscal path is fraught with risks, and the era of cheap borrowing is over.

The OBR's Admission: A Catalyst for Doubt

The OBR's March 2025 Economic and Fiscal Outlook revealed stark vulnerabilities. Its central forecast relies on unrealistic productivity growth of 1.0% annually—a rate that, if unmet, would widen the 2029-30 deficit by 1.4% of GDP. Worse, the OBR acknowledged it could not fully account for supply-side impacts of welfare reforms or global trade risks, such as a 20-point tariff hike on UK exports. These gaps exposed the fragility of its projections, with fiscal headroom now just £9.9 billion—a fraction of historical buffers. The IMF's subsequent critique of the UK's “fragile” fiscal framework only amplified concerns, noting that aging-related spending could balloon by 8% of GDP by 2050.

The Surge in Gilt Yields: A Market Reckoning

UK 10-year gilt yields have climbed to 4.65% (as of June 2025), up 0.39% year-on-year, reflecting markets pricing in higher risks. This divergence underscores a loss of confidence in the UK's fiscal management. The yield spike stems from:
1. Structural Debt Pressures: With debt-to-GDP nearing 100%, the UK now rivals Italy in sovereign risk metrics.
2. Inflation-Linked Debt Time Bomb: 25% of UK debt is inflation-indexed, costing £50 billion annually as prices rise.
3. Quantitative Tightening (QT) Headwinds: The BoE's unwinding of its £895 billion gilt portfolio—selling £100 billion annually—has exacerbated supply pressures, even as demand from pension funds and insurers wanes.

Why Confidence Won't Return Soon

The government's Spring Statement—touting a £10 billion fiscal buffer by 2029-30—failed to reassure. Analysts like Fidelity's Shamil Gohil argue this buffer is “insufficient” against a £1.5 trillion spending plan, while the OBR's own simulations show a 54% chance of missing deficit targets. Compounding this, rising interest rates and global trade tensions (e.g., US-EU auto tariffs) threaten GDP growth, now revised to just 1.0% in 2025.

Investment Implications: Underweight UK Debt, Hedge with Inflation-Linked Securities

The risks are clear: gilt yields will remain elevated as markets demand higher premiums for fiscal uncertainty. Investors should:
1. Underweight UK Sovereign Debt: Avoid long-dated gilts, which are vulnerable to further rate hikes and credit downgrades.
2. Hedge with Inflation-Linked Bonds (TIPS): While UK linkers are problematic due to their outsized inflation exposure, US TIPS or German inflation-linked bonds offer safer inflation hedging.
3. Short GBP Exposure: The pound's decline—already down 5% against the euro this year—is likely to accelerate as fiscal strains bite.

Conclusion: A New Reality for UK Markets

The UK's fiscal credibility is broken, and markets have priced in the consequences. With debt dynamics unsustainable and policy credibility eroded, investors must treat gilts as high-risk assets. Short-term gains in yield are outweighed by long-term risks of default, currency weakness, and inflation spirals. For now, the smart money is moving away from UK debt—and toward safer havens.

Final Note: Monitor gilt yields closely. A sustained breach of 5% would signal a full-blown fiscal crisis.