The cost of government debt has been on a roller coaster this year. On Thursday last week alone it rose and fell by almost 100bps. Given that gilt yields directly or indirectly set the price for vast amounts of corporate borrowing and – for now at least − play a huge role in determining whether we’ll all have to pay more taxes, it’s worth exploring what’s going on at the moment.

First though, the basics. A gilt is a bond issued by the UK government. It’s effectively an IOU where investors lend money to the state in return for regular interest payments and the promise of repayment at maturity. Because they are backed by the government, gilts are treated as the UK’s risk-free benchmark and underpin the pricing of many other financial assets. The interest rate on a gilt is the yield. This moves inversely to the price of a bond. So, when the price of a bond falls, its yield increases.

Usually, gilt yields are driven by interest rate expectations. But, the Bank of England (BoE) has cut interest rates four times over the last year and the yield on 10-year gilts is at the same level it was in early 2025. This means there’s clearly more going on under the surface.

What's keeping UK gilt yields elevated?

Last Thursday’s moves are a good example of where different forces are at work. Sir Keir Starmer faced another blow to his authority when further details about ties between Britain’s former Ambassador to the US, Peter Mandelson, and disgraced financier Jeffrey Epstein emerged. The odds that he wouldn’t be Prime Minister by the end of the year jumped from 50% to over 60%. That caused investors to view UK assets as a riskier bet, leading to a fall in the pound and a jump in gilt yields.

Why? The main reason is that candidates most likely to replace Keir Starmer as Prime Minister are seen as less committed to fiscal discipline than Starmer and Reeves, making gilts a riskier buy.

On the other side, even though the BoE kept interest rates on hold at 3.75%, the Monetary Policy Committee (MPC) appeared more dovish than expected. February’s meeting Minutes suggested that the next rate cut could come as quickly as March. We’d previously expected April and there’ll probably be another cut in the summer, which would take interest rates down to 3.25%.

In theory, then, interest rates should fall over the next year. That would drag down gilt yields, lower borrowing costs for businesses and consumers and make another round of tax increases less likely, providing a tailwind to the UK economy.

However, if political risks keep gilt yields elevated, then reductions in the Bank Rate won’t fully translate to lower funding costs in the economy. After all, why would you lend to a risky corporate that might go bankrupt for less than you could lend to the bankruptcy-proof government?

There are a couple of obvious potential pain points in the months ahead. The Gorton and Denton by-election on 26 February and the local elections on 7 May come to mind. This means we might see gilt yields move higher. But, we’re not facing another ‘Liz Truss’ incident. Interest rates are now on a downward trajectory and pension funds are much more robust, which’ll prevent the type of mega-moves we saw back then. Instead, this latest political plot-twist highlights how the risks from uncertainty could undermine an otherwise relatively positive outlook. Unfortunately, I suspect we’ll be writing a lot more on this over the next few months.

Post-Budget bounce continued into December

When the data’s published on Thursday, it’ll likely show the UK economy continued to grow in December. That’d be enough for the economy to eke out 0.2% growth on the quarter.

Starting with the production side of the economy, we expect no growth here. Surging North Sea oil loadings will boost mining production after a big drop in November. However, weak demand for household utilities will offset this. What’s more, the manufacturing sector will have little more to give now that Jaguar Land Rover is back at full production.

Dismal construction activity is likely to rebound a little in December − we think only by around 0.3%. A small improvement in an otherwise dismal PMI reading signalled the start of mildly improving sentiment in the sector. However, it did rebound much more strongly in January.

The services sector will therefore do much of the heavy lifting. Our NIQ RSM Hospitality Tracker showed total sales growth surging to 6.2% y/y in December, up from 3.1% in November. Translating that into a monthly move in the official data suggests a 4.1% gain in the sector. We forecast below this signal to factor in a 2.5% rise − the largest since May 2024 − over the Christmas period. What’s more, if official hospitality output was closer to our survey’s signal, then we expect that would be enough to lift growth to 0.2% m/m.

One area that’s more uncertain than usual and poses a risk to our December forecast comes from public services. Rising ‘flu cases have dragged down on education output, as school attendance falls, but boosted the healthcare sector as the number of patients rises. Offsetting the gain in healthcare activity in December was another round of strikes by resident doctors in England. However, a press release from the NHS suggests that hospitals have been able to deliver the majority of planned care, so we assume health output stagnated in December.

All told, we expect growth to come in at 0.1% m/m in December and 0.2% on the quarter. Further ahead, we expect output to rise at pace in January, consistent with the signal from surveys. This would put the economy on track to meet our forecast of 0.5% in Q1.

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