Debt market trends hint at cracks in UK's reserve currency: Rating agency

Recent moves in UK debt markets, where gilt yields have risen even though interest rates are being cut and the pound is falling, suggest that cracks may be appearing in Britain's reserve currency status, a credit rating agency has warned. 

A sharp sell-off in UK gilts earlier this month brought reminders of the 2022 "mini-budget" crisis, when the Conservative government of then-prime minister Liz Truss tried to ram through unfunded tax cuts. 

The trouble this time was largely pinned on shifts in global interest rate expectations. But bond market watchers have pointed to a notable change in UK market dynamics that seems to have taken root. 

 

Rather than attracting risk-adverse investors looking for a safe place to park their money when markets become volatile, gilts now tend to get sold off along with everything else when trouble hits. 

Dennis Shen, a top analyst at Scope Ratings, the only major agency headquartered in Europe, said evidence that the UK was becoming more vulnerable to these kinds of emerging market-style sell-offs would be a sign its AA rating may not be as robust as it once was. 

"If bond sell-offs sparking references to the mini-budget crisis of 2022 become a more regular feature of UK capital markets, this may suggest the safe-haven status is becoming less assured," Shen said. 

"This may be consequential for the AA rating," he added, saying the degree to which the coveted status was being eroded could be evaluated by shifts in "global holdings of reserves in gilts or sterling". 

Data from the International Monetary Fund shows that the pound's share in "official" sector foreign exchange reserves has nudged higher over the last decade. It accounted for 4.97 per cent in the third quarter of 2024 compared to 4.65 per cent in 2016, before the UK voted to leave the European Union. 

The amount of debt the UK is saddled with has surged though. 

It is now at nearly 100 per cent of GDP versus less than 45 per cent before the 2007-2008 global financial crisis. 

New government figures published on Thursday showed borrowing unexpectedly jumped to 17.8 billion pounds last month, hoisting pressure on UK finance minister Rachel Reeves to draw up budget cuts before a spending review in the summer. 

The figure was more than 25 per cent higher than economists had forecast and more than 10 billion pounds up on the same month last year, making it the highest December borrowing for four years. 

"The debt outlook is certainly also important," Shen said. 

Although occasional bond market sell-offs are not going to change the UK's debt outlook overnight, he said that if higher interest rates were sustained, it would gradually increase the level of UK debt and alter its structure. 

"Any meaningful weakening of our current outlook on the fiscal trajectory could affect the rating," Shen said.   

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