- UK gilt yields have risen sharply at the long end, less so at the short end
- A ‘bear steepener’ yield curve is therefore stalking the Chancellor of the Exchequer
- An austere Budget may be needed to quell bond vigilantes in November
- But the UK is not on its own here and ultimately the best cure for high yields could be high yields (providing inflation remains under control)
“The Chancellor of the Exchequer is under pressure to come up with a Budget on 26 November that pleases voters, Labour government loyalists and the financial markets, and the chances are at least one of them is going to be disappointed,” says AJ Bell investment director Russ Mould.
“Rising government borrowing costs, in the form of higher yields on its bonds, or gilts, mean Rachel Reeves will want to put together a tax-and-spending plan that appeases bond vigilantes. If she can propose a credible package then the best cure for those higher yields could simply be higher yields, as they will ultimately attract buyers who feel the rewards on offer will compensate for the risks posed by inflation, increasing debt and political uncertainty.
“Markets are undeniably edgy, as gilt yields are rising, and thus their prices are going lower, especially at the so-called long end, where the debt matures in 10 years’ time or more.
“At 4.73% at the time of writing, the yield on the benchmark 10-year gilt is within touching distance of the 4.89% sixteen-year high reached back in January. At 5.58%, the 30-year instrument’s yield is nearing a mark not seen since 1998.
“Worries over inflation and mounting government debt have prompted investors to demand higher yields on the longer-dated bonds issued by the UK to fund its overspending. In the end, if the supply of something goes up enough, its price will have to go down to stimulate demand and this is what is happening with long-dated gilts, since their price moves inversely to their yield (just the same as share prices).
Source: LSEG Refinitiv data
“The result is that it now costs the UK government more to issue 10-year debt than any of Portugal, Ireland, Italy, Greece and Spain, the so-called PIIGS whose sovereign borrowings caused such angst in the early 2010s and attracted so much criticism for the supposedly feckless policies that had contributed to them.
Source: LSEG Refinitiv data
“The same applies to 30-year paper. None of this, alas, looks like a vote of confidence in the UK’s economic outlook or Labour’s ability to stick to its carefully laid-out fiscal rules, at least without some politically unpalatable tax increases, spending cuts, or both.
Source: LSEG Refinitiv data
“When the 30-year yield was last this high, in 1998, Tony Blair was Prime Minister and Gordon Brown Chancellor of the Exchequer.
“Inflation was subdued, at below 2% based on the consumer price index, but annual GDP growth that year was 3.4%, a far superior rate of growth to that expected in 2025. The Bank of England base rate therefore exceeded 7% all the way through to November 1998, when rapid cuts were deployed by the then Bank of England Governor Eddie George, as part of a globally co-ordinated response to the Asian debt crisis and subsequently LTCM hedge fund failure.
“Healthy GDP growth, ‘Cool Britannia’ feelgood and financial market volatility were thus the order of the day 26 years ago.
“This time around, however, inflation, tariffs and government debt seem to be the key issues that are niggling bond vigilantes.
“Interest rate cuts from the Bank of England have made no difference, either. Benchmark gilt yields have gone up in the UK since the first reduction in headline borrowing costs of this cycle sanctioned by Governor Bailey and the Monetary Policy Committee a year ago.
“It will be some – if scant - consolation that the UK is keeping company here with America, where the Trump administration continues to run policies designed to stoke growth, generate tax revenue from tariffs and keep interest rates low, in an attempt to manage a galloping Federal debt and interest bill. Nor will the Labour government, Treasury or Bank of England take comfort from how France is in the same situation, especially as efforts to impose any kind of fiscal order have led to public unrest, while coming to nought. This week’s vote of confidence in the current Prime Minister, François Bayrou, may only heighten worries about France’s ability to manage its borrowing.
Source: LSEG Refinitiv data
“Over the last month, the UK two-year gilt yield is up by sixteen basis points (0.16%), the five-year by eighteen (0.18%), 10-year by twenty-one (0.21%) and then 30-year by twenty-five (0.25%).
“As a result, the yield curve shows something a little more akin to a ‘normal’ yield curve, where lenders (or bond buyers) demand a higher return from longer-dated paper to compensate themselves for the increased scope for something to go wrong during the additional life time of the gilts, such as changes in interest rates, higher inflation or, at worst, a default by the issuer (or borrower).
Source: LSEG Refinitiv data
“In some ways, the Chancellor may draw a little comfort from this, since the worst of the gilt yield increases lie at the long end. Ten, twenty-, thirty-year yields do affect the overall government interest bill, but these gilts are a long-term preoccupation for financial markets.
“The yield on the two- and five-year maturities matter far more from the point of view of the economy and growth in the near term, as they form the reference point for mortgage rates. Over the past six months, two- and five-year yields are actually down, as investors position themselves for possible further interest rate cuts from the Bank of England, so the news is not all bleak.
Source: LSEG Refinitiv data
“However, the price action of the past month means the UK yield curve is offering a so-called ‘bear steepener,’ when both short- and long-term yields are rising but long-term ones are rising faster to widen the gap between the two.
“This can be seen in the spread, or rate differential between two- and ten-year gilts, or two-and thirty-year gilts.
Source: LSEG Refinitiv data
“A continuation of these trends could be the worst of all worlds, for consumers, politicians and investors alike.
“From an investment point of view, this can be bad news for bonds in particular, as prices fall when yields rise, and it can be a sign inflation is on the rise. A sustained bout of inflation would erode the real-terms value of the pre-set coupons paid over the fixed life of the gilt or bond.
“It could be a challenge for share prices, too, as it combines higher discount rates (that lower the theoretical value of the long-term cash flows of long duration sectors like tech and biotech) with tighter monetary policy that hits the earnings power of short-duration, cyclical industries.
“This means it is not just bond vigilantes, but equity investors as well, who will have keep tabs on the rumour mill regarding possible policy interventions from Chancellor Rachel Reeves ahead of the Budget as she looks for a way to keep financial markets, her own backbenchers and voters happy, while sticking to her own ‘fiscal rules’ and the government’s growth agenda.”
