UK bond yield surge – more than meets the eye

Posted 10 January 2025

Bond market woes took centre stage again this week. Much of this was driven by the strength of the US economy, as shown by today’s strong employment data and signs that US consumer services are powering ahead (although, interestingly, wages rises were well-contained). We should bear in mind potential political effects, however, which need to be monitored this year.

The US influence on global yields is obvious, but British media was more focussed on the sharp rise in UK yields – which rose more than other markets. Yields on long-term government debt jumped to their highest levels in decades and sterling sank in value, as investors appeared to lose faith in the UK’s economy and fiscal policy. The financial media presented this as a UK-specific problem, but we believe there is more going on here. As the chart below shows, there is a broader squeeze on global capital market liquidity, and signs that long-term risk appetite is waning, or at least pausing. This is not yet affecting stock markets, but it suggests trouble is brewing.

Gilts are very cheap – but they could get cheaper.
To expand on the introduction above, the sell-off in UK government bonds ( or gilts) is not another ‘Liz Truss moment’. Yields might be higher than in October 2022, but the increase compared to other bond markets is not close. It has, however, been driven by the same underlying weakness: excessive gilt selling from overleveraged UK pension funds. Gilt traders are clearly fearful of government spending and debt instability, but the unwinding of these positions has played out over months rather than days, as it did in 2022.

We see evidence of this in the yield changes between short-term interest rates and longer-dated government bonds. The press focussed on the weak economy, which is most closely related to short rates – but these did not change much. It was long-term real (inflation-adjusted) yields that increased, which – absent higher interest rates or inflation – should indicate stronger growth expectations. This is because the long-term rate of return should equal long-term growth.

Because of the bond sell-off, the UK’s long-term real yield rose above 2.5%. But nobody thinks long-term UK growth has improved that much. So, the gilt sell-off that pushed up real yields must have been caused by other factors. The most obvious factor is the structural reduction in gilt holdings by pensions funds, who got burned by the Liz Truss ‘mini budget’ and have been reducing their holdings since.

That explains why UK gilt yields have risen above others recently, but it does not explain why bond yield rises accelerated everywhere this week. Against the long term inflation and growth outlook, bonds seem to now offer a very attractive yield which should make them a ‘buy’ rather than a ‘sell’.

Turmoil points to mistrust, and not just in the UK.
The problem is that the bond market’s analysis is not as emotionless as our interpretation above, which can drive the direction of bond yields even more. There is clearly a lot of distrust in what the government will do and how gilts will perform. The treasury’s fiscal rules bind it to borrowing costs – and therefore to the bond market itself. Either the treasury will have to tighten its spending and hurt an already weak UK economy, or break its own rules and damage its credibility with bond markets. As of now, gilt traders appear to strongly expect the latter which discourages potential gilt buyers – and nothing the government says can convince them otherwise.

Notably, investor disbelief is not only a UK phenomenon. Despite the intense focus on Labour’s policies, it is worth noting that UK yields are still broadly tracking US treasury yields (though as stated before, the premium between the two did increase this week). The latter have been trending up for a while, and we have repeatedly pointed out here that our measures of US government credit worthiness and long term bond market stability have been deteriorating.
We have argued for some time that these US bond moves have been about perceptions of instability – either in terms of public debt, or the health of US institutions more broadly. That instability clearly increased again this week. President-elect Donald Trump threatened military action against a NATO ally, while his close adviser Elon Musk has been overtly trying to install his preferred far-right candidates in both the UK and Germany.

Aversion to taking on long term risks are rising, which could mean trouble for equities.
That might all sound very abstract and peculiar to the bond markets, but instability has a real impact on wider capital markets. The deterioration of government credit-worthiness, for example, suggests that investors are generally less keen on having long-term risks on their balance sheets. This aversion is happening everywhere.

If this persists, it could be a real problem for long-duration investments like equities. For a long time, investors have been happy to invest in long-term assets, which has underpinned the stellar performance of US stocks in particular. It now looks like that appetite for long-term risks is fading. Notably, this has recently coincided with increased volatility in US tech stocks – the stereotypical long-duration assets.

To be clear, there is no sign of a broad equity sell-off yet. Nevertheless, it is an early warning sign we must be wary of. The broad increase in real yields, through the selling pressure on government bonds, also effectively means that market liquidity for long term assets has tightened. Less liquidity always means a higher ‘gap risk’ for long duration asset prices. UK bond troubles might look and have sounded UK specific, but liquidity and risk appetite has been declining across global markets since December, when the US Fed signalled fewer interest rate cuts and president elect Trump began his aggressive policy talk.

To conclude, this week’s UK bond yield headlines are only to some degree UK specific. Global bond yield moves likely reflect waning (bond) investor risk appetite, in reaction to political uncertainty. We think this should remind politicians that, regardless of how strong a mandate they think they have from their respective electorates, capital markets (and bond markets in particular) will hold them to account, regardless of their present popularity with the wider public.

This week’s yield movements are not yet a glaring signal – but it is one we have to take seriously. Without adequate political counteraction, there is a rising possibility of a minor equity market shakeout in the coming weeks.