Scope Ratings affirmed the UK’s sovereign credit rating in October 2024, assigning a Stable outlook. The next scheduled rating review is on 28 March. However, potential downward pressure on this outlook could arise from increased instability in sterling and gilt markets during crises or a significant escalation of fiscal risks beyond Scope’s October 2024 assessment.
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The recent sharp decline in gilt prices highlights the increased sensitivity of UK government bonds to market sentiment following the 2022 mini-budget crisis. Ten-year gilt yields surged from 4.2% in early December 2024 to post-financial crisis highs of 4.9% by mid-January. While yields have partially retreated, they remain elevated at around 4.6%, exceeding the 2024 average of 4.1%.
Global Bond Market Volatility and UK Vulnerability
The UK experienced the most significant rise in bond yields among G7 nations between December and January, raising concerns about its perceived safe-haven status. Gilts, traditionally considered stable assets, have faced disproportionate sell-offs during recent periods of stress. This increased volatility, exceeding levels seen during the 2008-09 financial crisis, suggests heightened risk for the UK government as a borrower.
Figure 1. Gilt market volatility has reached multi-decade highs. Source: Macrobond, Scope Ratings calculations
While this volatility is partly attributable to the global impact of the cost-of-living crisis on sovereign risk, the UK’s vulnerability has drawn comparisons to riskier asset classes and sovereign borrowers lacking safe-haven and reserve-currency advantages. This vulnerability stems from the UK economy’s heightened exposure to inflationary pressures.
Hedge Fund Influence and Market Dynamics
The evolving investor base for UK government bonds may be exacerbating market fluctuations. The substantial increase in outstanding UK sovereign debt, particularly since the pandemic, has not been matched by a corresponding increase in the capacity or willingness of commercial banks to absorb new issuances. With reduced Bank of England intervention through quantitative easing, hedge funds have become increasingly crucial in balancing supply and demand in the gilt market.
Hedge funds now account for almost 30% of gilt trades, double their share in mid-2018. Their increased participation, characterized by shorter holding horizons and less “home bias,” potentially amplifies market swings during crises. This raises the likelihood of gilt holders selling during periods of stress rather than holding or buying, potentially undermining market resilience.
This shift towards pro-cyclical behavior in UK markets during crises poses a significant concern for the UK’s AA credit rating, which implies a comparatively risk-free profile.
Sterling’s Resilience Amidst Global Shifts
Despite challenges like Brexit, global reserve holdings in sterling have remained relatively stable at 5.0% as of September 2024. Cross-border lending, global payments in sterling via SWIFT, and foreign exchange turnover in sterling have also seen little change recently.
This stability has been a cornerstone of Scope’s UK sovereign credit rating since 2017, underpinning its through-the-cycle resilience despite weaker economic growth and budgetary performance. However, evolving global financial dynamics, driven by US policies and the emergence of alternative financial architectures centered around the renminbi and the rouble, pose long-term risks to currencies like sterling.
UK Debt Outlook and Fiscal Challenges
The UK’s historical reliance on its safe-haven status and a low-rate environment to support expansionary fiscal policies is facing increasing challenges. Current market dynamics necessitate greater fiscal discipline, requiring the government to balance pro-growth initiatives with budgetary consolidation. This includes potentially tougher measures on current spending, higher taxes, and restoring confidence in fiscal rules, particularly given weaker economic projections.
Figure 2. Public-debt projections on the United Kingdom compared against those for select peer sovereigns. Source: IMF World Economic Outlook historical data, Scope Ratings forecasts
Scope forecasts UK general government debt to reach 114.8% of GDP by 2029, up from 100.1% at the end of 2024. Net interest payments are projected to rise to 8.1% of general government revenue by 2029, nearly triple the 3.1% low in 2020. This trajectory is steeper than Scope’s October 2024 projections due to lower growth forecasts (0.9% for 2025 and 1.3% for 2026), higher financing rate assumptions, and slightly higher primary deficit assumptions.
While the UK’s debt ratio remains moderately below that of France (rated AA- by Scope, with projected debt of 119% of GDP by 2029), it is rising more rapidly. UK debt also remains significantly lower than that of the United States (rated AA by Scope, with projected debt of 134% of GDP by 2029). Addressing the budget deficit could help mitigate supply-demand imbalances in debt markets.
Conclusion
The UK’s sovereign rating faces challenges from heightened market volatility, evolving investor dynamics, and growing fiscal pressures. While sterling has demonstrated resilience, long-term risks persist. Addressing these challenges through fiscal discipline and adapting to the shifting global financial landscape will be crucial for maintaining the UK’s creditworthiness and ensuring the stability of its financial markets.
