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UK government bond yields highest in 16 years

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Higher yields add to worries over UK government finances

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Finance ministry says it has 'iron grip' on public purse

(Updates prices in mid-afternoon European trading)

By Amanda Cooper and Harry Robertson

LONDON, Jan 9 (Reuters) - The pound hit its lowest since

late 2023 on Thursday, under pressure from a selloff in global

bonds that has driven the UK government's borrowing costs to

their highest in over 16 years, which has reignited concern

about Britain's finances.

Sterling was last down 0.5% at $1.2305, having

fallen by as much as 1.6% earlier to its lowest since November

2023, while the cost of hedging against bigger price swings over

the coming month jumped to its highest since the March 2023

banking crisis.

Global bond yields have soared this week on the back of

concern about rising inflation, reduced chances of a drop in

interest rates, uncertainty over how U.S. President-elect Donald

Trump will conduct foreign or economic policy and the prospect

of trillions of dollars in extra debt.

The UK market has been hit particularly hard. Benchmark

10-year gilt yields have spiked by a quarter point

this week alone to their highest since 2008, as confidence in

Britain's fiscal outlook deteriorates. By the afternoon in

London on Thursday, some of the selling pressure had ebbed,

leaving yields unchanged on the day around 4.81%.

Finance minister Rachel Reeves is facing her first major

test, as turmoil in the bond market could force her to cut

future spending.

Ordinarily, higher gilt yields would support the pound, but

right now, that relationship has broken down, reflecting

investors' worry about the country's finances.

"This is the bond market starting to discipline the UK

government. And at the moment they want to fight the market, and

that never ends well," Lloyd Harris, head of fixed income at

Premier Miton Investors, said.

In a statement late on Wednesday, the UK finance ministry

said it would maintain "an iron grip" on the public finances.

BRITAIN FACING SLOWER GROWTH, PERSISTENT INFLATION

Sterling has been one of the best-performing currencies

against the dollar in the last couple of years, largely because

of the Bank of England's policy of keeping UK interest rates

higher for longer than other major central banks, which creates

an incentive for foreign investors to earn interest from UK

assets.

Trump's proposed policies on trade tariffs and immigration

carry the risk of fuelling U.S. price pressures, thereby

limiting the Federal Reserve's ability to cut rates, which has

sent the dollar soaring against virtually every other currency.

The derivatives market shows traders believe the Fed will

deliver one rate cut this year, but are not fully pricing in the

chance of a second. The UK market, meanwhile, shows almost

identical expectations for the BoE.

Britain is struggling with slower growth, persistent

inflation and a deteriorating labour market, lagging behind the

United States, which shows resilience in virtually every area.

"We had this story of the UK being better than Europe, the

currency is doing better, interest rates are higher,

everything's fine (for sterling)," Societe Generale chief FX

strategist Kit Juckes said.

"The danger now is people start to get a general sense of

why not use sterling for the short side of our long dollar

trade," he said.

Britain's economy is flat-lining, while the labour market is

deteriorating rapidly, as employers grapple with tax rises in

the Reeves' October budget, which contained the biggest overall

tax increases since 1993.

The yield on 30-year gilts has hit its highest

since 1998 above 5.3% this week, echoing the rise in global

long-dated yields.

The last time UK debt was in the eye of the storm was

September 2022, when then-Prime Minister Liz Truss unveiled

budget plans that contained billions in unfunded tax cuts that

sent gilts into freefall, battered the pound and forced the BoE

to step in to stabilise the market.

This week's move is nowhere near that of late 2022, when

10-year gilts rose a full percentage point in a week and the

pound hit record lows against the dollar.

Indeed, PIMCO, one of the world's largest bond investors,

told Reuters late on Wednesday it was still positive about UK

debt and said much of the rise in gilt yields was a function of

the increase in U.S. Treasury yields, rather than a reflection

of deeper problems at home.

(Additional reporting by Naomi Rovnick. Editing by Bernadette

Baum, Mark Potter and Emelia Sithole-Matarise)