The shadow of European debt has never faded! UK long-term bond yields are approaching the 1998 high, facing the risk of "stagflation."

Against the backdrop of rising global bond yields, concerns about the UK economic outlook have intensified, leading to a sharp sell-off of its long-term government bonds. The UK's borrowing costs have approached the highest levels since the beginning of this century, and the economy is facing an increasing risk of "stagflation."

On Wednesday, the yield on the UK's 30-year government bonds surged to 5.64% during early trading, the highest point in nearly four months, just a step away from the historical high set in 1998. This trend undoubtedly puts immense pressure on UK Chancellor of the Exchequer Rachel Reeves as she prepares the autumn budget.

The "UK Dilemma" Amidst a Global Bond Market Sell-off

Recently, bond yields in major global economies have generally risen. However, UK government bonds (Gilts) have been particularly hard hit in this round of sell-offs.

Data shows that since early August, the yield on the UK's 30-year government bonds has increased by 0.23 percentage points, far exceeding the increases of 0.13 percentage points in Germany and 0.06 percentage points in the United States during the same period.

Market analysis suggests that the underperformance of UK government bonds compared to US bonds is largely due to diverging central bank policy expectations. Mike Riddell, a fund manager at Fidelity International, explained, "The Federal Reserve has signaled more rate cuts, while the Bank of England has leaned hawkish in its statements in recent weeks." Currently, the market predicts that the Bank of England will only cut rates once in the next 12 months, while expectations for the Federal Reserve's rate cuts reach as high as four times.

Mark Sobel, chair of the OMFIF US division and former US Treasury official, pointed out that the UK is "trapped in a fiscal quagmire of sluggish growth and high taxes," similar to other large economies. He added, "The massive debt and deficits will persist, putting upward pressure on bond yields."

Intensifying "Stagflation" Risks and Constrained Policy Space

Bond fund managers generally believe that the UK is facing increasing "stagflation" risks—where inflation remains high while economic growth stagnates.

Currently, the UK's inflation rate is still close to 4%, making it difficult for the Bank of England to stimulate the sluggish economy through rate cuts. The continuously rising bond yields are also severely squeezing the government's fiscal space.

Robert Dishner, a senior portfolio manager at US asset management firm Neuberger Berman, stated that if the government chooses to raise taxes to improve finances, it could "further drag down economic growth and exacerbate the current stagflation problem."

According to Capital Economics, if the current yield levels persist, Chancellor Reeves' fiscal space will shrink sharply from £9.9 billion at the spring budget to £5.3 billion. Analysts warn that to fill the public finance gap, she may need to raise as much as £27 billion in the budget.

Central Bank in a Dilemma, Market Fears "Panic Eruption"

The surge in yields has also put increasing pressure on the Bank of England, with the market calling for it to slow down or even halt its Quantitative Tightening (QT) plan.

In response to past financial crises, the Bank of England had purchased a large amount of bonds, leading to a sharp expansion of its balance sheet. Currently, the bank is reducing its balance sheet at a rate of £100 billion per year, which includes direct bond sales. Analysts believe this move further depresses government bond prices and pushes up yields.

Mark Dowding, Chief Investment Officer at RBC BlueBay Asset Management, warned that investors are concerned about "inflation and the credibility of UK policy." He believes that unless the government cuts spending and the central bank stops quantitative tightening, "the fiscal hole will continue to grow, and the market may experience a 'market tantrum.'"

Nevertheless, there are still some noteworthy details: as the most closely watched benchmark for long-term borrowing costs, the yield on UK 10-year government bonds is currently at 4.74%, still below the 16-year high reached in January of this year. Meanwhile, the pound, which has been under pressure due to debt issues, has actually risen by 2% against the dollar this month