US Strikes on Iran Push Oil Prices Higher, Fueling Borrowing Cost Increases

Borrowing costs have reached their highest level in two months, climbing above 5% for ten-year gilt yields for the first time since May, as escalating hostilities in the Middle East drive oil prices upward. Brent crude surpassed $86 a barrel, reaching its highest point in nearly a month.

The United States has conducted strikes against Iran for a third consecutive night. President Donald Trump has also threatened to reinstate a blockade of the Strait of Hormuz and proposed a 20% fee for passage through the vital waterway.

Bank of England Governor Andrew Bailey acknowledged that the renewed conflict has heightened risks to financial stability. "I don't certainly feel qualified to judge how long this is going to go on for in terms of this resumption of hostilities and how it's going to end," Bailey told the Treasury Select Committee. "But it underlines that this is going to be an unstable process for the foreseeable future."

The increased risk of further inflation has led investors to anticipate two interest rate hikes this year, driven by concerns over higher energy prices. These higher borrowing costs are expected to create significant fiscal challenges for the incoming Prime Minister, Andy Burnham, who is set to take office next Monday.

Susannah Streeter, chief investment strategist at Wealth Club, noted that "Mr Burnham will inherit one of the toughest fiscal challenges of any incoming Prime Minister in decades." She added that meeting demands to repair public finances, fund public services, and stimulate economic growth would likely necessitate tax increases, according to investors.

Market sentiment has been cautious regarding the potential direction of the new government, with an anticipated shift to the left potentially unsettling financial markets. While the reaction to Burnham's campaign has been muted, his selection of a Chancellor could lead to a further sell-off of UK government bonds. Asset manager Rathbones has reportedly reduced its holdings of UK gilts to mitigate risks associated with "fiscal irresponsibility."