The thermometer in Berlin touched 41.3 degrees Celsius on Wednesday, smashing the previous German record. It is not the heat that worries me. It is the fiscal fever that follows. As the continent swelters, the UK braces for emergency measures, and I can already see the gilt yield curve start to sweat.
In the City, we deal in liquid assets. But the only thing liquid right now is the sweat on the brow of a farmer in East Anglia watching his barley wither. The immediate economic impact of this heatwave is clear: agricultural yields will tumble, pushing food prices higher. The ONS already reported CPI inflation at 8.7% in June. This heatwave will add another 0.5 percentage points to that figure by September, I suspect. The Bank of England will have to respond with higher rates. The market expects 25 basis points in August. I think they will need to go further. 50 basis points, perhaps. The bond market is already pricing in a terminal rate of 6%. That is a barbell for the economy.
But the deeper problem is the fiscal drag. The government will be tempted to announce emergency support for farmers, energy subsidies for cooling, perhaps even a cut in green levies. All of that is spending. All of that is more debt. The UK already borrowed £19.8 billion in May, the second highest May on record. The Chancellor is running out of headroom for his fiscal rules. The bond market will demand a premium for this risk. The 10-year gilt yield is already flirting with 4.5%. A blowout above 5% would be the real crisis.
Look at Germany. They will need to spend on cooling shelters, health services for the elderly, and infrastructure resilience. The German finance ministry may have to suspend its own debt brake. That would be a signal that even the most fiscally disciplined nation can buckle under extreme weather. Capital flight from the eurozone will intensify. Where does it go? It goes to the dollar. The DXY index is already at 103. A stronger dollar means higher import prices for the UK. A vicious cycle.
The emergency measures the UK is bracing for are not just about public health. They are about market confidence. If the government signals that it is willing to spend whatever it takes to manage the heatwave, the bond market will test its resolve. The ECB has already started hiking, but the Bank of England is behind the curve. The combined effect of fiscal profligacy and monetary tightening is stagflation. The worst of all worlds.
I am reminded of the summer of 1976. That heatwave broke records and broke the economy. Labour's borrowing binge led to the IMF bailout in 1976. The parallels are not exact, but the fundamentals are similar. Inflation was high, growth was low, and the government was overpromising. Today, we have a net-zero transition that is adding to energy costs, a war in Ukraine, and a divided political landscape. The heatwave is a shock. But the system is brittle.
The British brand of resilience is being tested. The government will announce emergency measures. They will be necessary, but they will be costly. The yield curve is steepening. The long end is repricing risk. The short end is rising on hawkish central bank expectations. Investors should reduce exposure to UK gilts, increase cash holdings, and hedge against energy price volatility. The market will not wait for the temperature to drop. It will adjust in real time.
So as the mercury melts records, I am watching the yield curve. That is the real fever chart of the nation. If the spread between two-year and ten-year yields widens further, the market is betting on a recession. The heatwave will be uncomfortable. But a fiscal crisis will be catastrophic.
