Long-term UK borrowing costs are likely to remain elevated near 5% even if geopolitical tensions in the Middle East ease according to the National Institute of Economic and Social Research (NIESR).

NIESR’s latest market analysis suggests only around 45 basis points of the recent increase in gilt yields can be attributed to the Middle East conflict.

A further 70 basis points reflects higher longer-term real interest rates and an increased term premium, suggesting much of the upward pressure on borrowing costs could prove more persistent.

The findings have implications for the mortgage market because gilt yields and wider market interest-rate expectations feed into swap rates and lenders’ funding costs, which influence fixed mortgage pricing.

GLOBAL PRESSURES

NIESR estimates around 40 basis points of the increase reflects higher global long-term real interest rates associated with the US artificial intelligence investment boom.

It said heavy long-term borrowing by large technology companies, combined with expectations of stronger future economic growth, has contributed to the increase.

A further 25 basis points is attributed to a higher term premium, with investors demanding greater compensation to absorb substantial government and corporate debt issuance.

UK 10-year gilt yields have increased by 113 basis points since February and reached their highest level in almost two decades.

That suggests an easing in energy prices or geopolitical tensions would not necessarily reverse all of the increase in longer-term borrowing costs.

CASE FOR LOWER BANK RATE

However, NIESR said the rise in global long-term real rates could strengthen the case for a lower Bank Rate in the UK.

It argued that higher global rates have tightened UK financial conditions without being accompanied by a corresponding increase in domestic economic demand.

As a result, Bank Rate may need to be lower in the near term than would otherwise have been necessary to prevent monetary conditions becoming too restrictive.

BUDGET RISK

The analysis also warns that elevated gilt yields leave the UK’s public finances increasingly exposed ahead of the Budget.

NIESR estimates that if the 10-year yield remains above 5%, maintaining government debt at 94% of GDP would eventually require a primary budget surplus of between 1.6% and 2% of GDP, compared with a primary deficit of 1.3% in 2025-26.

David Aikman (main picture, inset), director at NIESR, said: “The UK’s fiscal position is not the dominant driver of this year’s rise in yields, but high debt and weak growth leave the UK highly exposed to global shocks of this kind.

“That makes the upcoming Budget both a risk and an opportunity. A poorly received Budget could lead to a sharp repricing of gilts. Equally, a well-received one with a credible plan to bring debt down could also bring borrowing costs down and start a virtuous circle.

“To use the famous quip, these are circumstances in which you want to be ‘the best-looking horse in the glue factory’.”