UK Finance Minister Rachel Reeves’ spending plans risk creating ‘a snowball effect’ that pushes borrowing costs higher

Britain’s government is planning to ramp up public spending — but market watchers warn the proposals risk sending jitters through the bond market further inflating the country’s $143 billion-a-year interest payments.

U.K. Finance Minister Rachel Reeves on Wednesday announced the government would inject billions of pounds into defense, healthcare, infrastructure, and other areas of the economy, in the coming years. A day later, however, official data showed the U.K. economy shrank by a greater-than-expected 0.3% in April.

Funding public spending in the absence of a growing economy, leaves the government with two options: raise money through taxation, or take on more debt.

One way it can borrow is to issue bonds, known as gilts in the U.K., into the public market. By purchasing gilts, investors are essentially lending money to the government, with the yield on the bond representing the return the investor can expect to receive.

Gilt yields and prices move in opposite directions — so rising prices move yields lower, and vice versa. This year, gilt yields have seen volatile moves, with investors sensitive to geopolitical and macroeconomic instability.

The U.K. government’s long-term borrowing costs spiked to multi-decade highs in January, and the yield on 20- and 30-year gilts continues to hover firmly above 5%.

Official estimates show the government is expected to spend more than £105 billion ($142.9 billion) paying interest on its national debt in the 2025 fiscal year — £9.4 billion higher than at the the time of the Autumn budget last year — and £111 billion in annual interest in 2026.

The government did not say on Wednesday how its newly unveiled spending hikes will be funded, and did not respond to CNBC’s request for comment about where the money will come from. However, in her Autumn Budget last year, Reeves outlined plans to hike both taxes and borrowing. Following the budget, the finance minister pledged not to raise taxes again during the current Labour government’s term in office, saying that the government “won’t have to do a budget like this ever again.”

Andrew Goodwin, chief U.K. economist at Oxford Economics, said Britain’s government may be forced to go even further with its spending plans, with NATO poised to hike its defense spending target for member states to 5% of GDP, and once a U-turn on winter fuel payments for the elderly and other possible welfare reforms are factored in.

Additionally, Goodwin said, the U.K.’s Office for Budget Responsibility is likely to make “unfavorable revisions” to its economic forecasts in July, which would lead to lower tax receipts and higher borrowing.

“If recent movements in financial market pricing hold, debt servicing costs will be around £2.5bn ($3.4 billion) higher than they were at the time of the Spring Statement,” Goodwin warned in a note on Wednesday.

Mel Stride, who serves as the shadow Chancellor in the U.K.’s opposition government, told CNBC’s “Squawk Box Europe” on Thursday that the Spending Review raised questions about whether “a huge amount of borrowing” will be involved in funding the government’s fiscal strategies.

“[Government] borrowing is having consequences in terms of higher inflation in the U.K. … and therefore interest rates [are] higher for longer,” he said. “It’s adding to the debt mountain, the servicing costs upon which are running at 100 billion [pounds] a year, that’s twice what we spend on defense.”

“I’m afraid the overall economy is in a very weak position to withstand the kind of spending and borrowing that this government is announcing,” Stride added.

Stride argued that Reeves will “almost certainly” have to raise taxes again in her next budget announcement due in the autumn.

“We’ve ended up in a very fragile situation, particularly when you’ve got the tariffs around the world,” he said.

Rufaro Chiriseri, head of fixed income for the British Isles at RBC Wealth Management, told CNBC that rising borrowing costs were putting Reeves’ “already small fiscal headroom at risk.”

“This reduced headroom could create a snowball effect, as investors could potentially become nervous to hold UK debt, which could lead to a further selloff until fiscal stability is restored,” he said.

Iain Barnes, Chief Investment Officer at Netwealth, also told CNBC on Thursday that the U.K. was in “a state of fiscal fragility, so room for manoeuvre is limited.”

“The market knows that if growth disappoints, then this year’s Budget may have to deliver higher taxes and increased borrowing to fund spending plans,” Barnes said.

However, April LaRusse, head of investment specialists at Insight Investment, argued there were ways for debt servicing burdens to be kept under control.

The U.K.’s Debt Management Office, which issues gilts, has scope to reshape issuance patters — the maturity and type of gilts issued — to help the government get its borrowing costs under control, she said.

“With the average yield on the 1-10 year gilts at c4% and the yield on the 15 year + gilts at 5.2% yield, there is scope to make the debt financing costs more affordable,” she explained.

However, LaRusse noted that debt interest payments for the U.K. government were estimated to reach the equivalent of around 3.5% of GDP this fiscal year, and that overspending could worsen the burden.

“This increase is driven not only by higher interest rates, which gradually translate into higher coupon payments, but also by elevated levels of government spending, compounding the fiscal burden,” she said.