Yields on UK government bonds, or gilts, have surged to multi-decade highs, placing significant strain on public finances and rattling investor confidence. The yield on 30-year gilts has reached its highest level since 1998, while 10-year yields now stand at 4.85% (at time of writing), a stark rise from 3.75% in September. This rapid shift underscores a challenging environment for fiscal policy, eroding the Chancellor’s fiscal headroom of approximately £9.9 billion, secured through October’s tax-raising budget. The prospect of delivering Labour’s public spending commitments now appears increasingly dubious.
This period of upheaval in the bond market recalls the turbulence of the Liz Truss mini-budget in 2022. However, fortunately, the current situation is much less catastrophic. The pound remains significantly stronger than during that episode, and the structural vulnerabilities tied to liability-driven investment (LDI) schemes have been mitigated. Yet, the sharp sell-off in gilts has had consequences, including an increased supply of sterling in currency markets, which has led to downward pressure on the pound.
Inflation, oversupply, and poor economics
Some of underlying causes of the gilt market turmoil reflect deep-seated economic challenges. Chief among them is inflation, which remains persistently high, coupled with broader concerns about the UK’s fiscal position. The spectre of stagflation looms large—an economic condition marked by stagnant growth, rising unemployment, and inflationary pressures. This scenario poses a particularly difficult policy dilemma, with few options for fiscal or monetary intervention.
Oversupply of debt by the Treasury has further exacerbated the issue. The UK is on track to issue nearly £300 billion in gilts this year, driven by record Treasury borrowing and the Bank of England’s quantitative tightening programme. This glut of gilts has coincided with waning demand, particularly from foreign investors, allowing investors to command higher yields. Moreover, some investors may be deterred by the sheer scale of UK government debt, raising concerns about long-term fiscal sustainability. Indeed, the issue of excessive government indebtedness across many nations is creeping to the fore as a major concern for investors.
The effects of the market sell-off
The immediate consequence of rising gilt yields is an increase in borrowing costs for the UK government. Higher yields mean the government must allocate more of its budget to servicing debt, constraining its ability to fund public services or infrastructure projects. Labour, which has pledged not to raise major taxes such as income tax, finds itself with limited room to manoeuvre. The risk of tax increases or spending cuts could further undermine economic activity, intensifying political and market scrutiny.
The spillover from the gilt market is likely to be felt early by consumers in the housing market, as rising bond yields push mortgage rates higher. Mortgage pricing often correlates with gilt yields, especially for longer-term fixed-rate products. As lenders face higher funding costs, these increases are passed on to borrowers, placing additional strain on household finances. This risks suppressing consumer spending, which is already under pressure from inflation, record high taxes and loss of confidence.
The UK may now be facing a feedback loop in fiscal and monetary policy. Rising yields signal investor concerns over the government’s fiscal position, compelling the government to raise taxes or cut spending to manage borrowing costs. These measures, however, could dampen economic growth, exacerbating the very vulnerabilities that investors are reacting to. This self-reinforcing cycle threatens to entrench fiscal instability if left unaddressed.
This is not exclusively a UK-specific issue
While the UK has been particularly affected, the gilt market sell-off is far from an isolated event. Across the Atlantic, US Treasuries have faced similar turmoil, with yields on 10-year bonds rising sharply since September, closely mirroring the movement in gilts. This trend has been driven by persistent inflation, a robust labour market, and mounting concerns over the federal budget deficit. Adding to the unease is the return of Donald Trump to the presidency, with fears that his policies could stoke inflation and further widen fiscal imbalances. These concerns are considered by many analysts to be the chief antagonist behind the sell-off in government bonds globally, with European yields also climbing in response to similar pressures.
Looking ahead
Despite the current turmoil, many analysts contend that the extent of the gilt sell-off is not fully justified by the underlying economic data. With the UK economy expected to contract further in 2025, interest rates are forecast to continue to decline, which would, in turn, exert downward pressure on bond yields. If conditions were to deteriorate significantly, intervention by the Bank of England could become a possibility. This might involve pausing quantitative tightening or even reintroducing quantitative easing to stabilise the market. However, such measures appear unlikely at this stage, as policymakers have adopted a cautious, wait-and-see approach, particularly given that the bond sell-off is a global phenomenon rather than one isolated to the UK.
Our Investment Strategy
Despite the challenges facing the gilt market, government bonds continue to play a critical role in diversified, multi-asset portfolios. Historically, bonds have offered an inverse correlation to equities, providing stability during periods of market volatility. However, in stagflationary environments, both asset classes can face headwinds, as bonds are weighed down by high interest rates and equities by low growth.
We reduced our gilt allocation last summer to lower sensitivity to interest rate movements. This prescient decision has helped lower the portfolios’ exposure to the worst of the recent sell-off. Nevertheless, we remain committed to maintaining a balanced approach. Elevated gilt yields present a compelling investment case, particularly as market expectations shift towards widely anticipated rate cuts in 2025. Lower rates would reduce borrowing costs, increasing the value of bonds purchased at current, elevated, yields. Indeed, the majority of our exposure to gilts is through strategic bond funds, funds which are ideally positioned to capitalise on market volatility.
As always, diversification is paramount. Over – or under- concentration in any single asset class risks increasing portfolio volatility. By maintaining a prudent allocation to gilts, we aim for stability whilst positioning for future opportunities. We will continue to monitor developments closely and provide timely updates on any significant changes in market conditions.
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