UK GILTS UNDER PRESSURE: UNDERSTANDING THE BOND SELL-OFF AND ITS IMPLICATIONS

This article was written by Sayak Sunder Das on the 20th of January 2025

The UK gilt market has found itself at the centre of a global bond sell-off. Yields on 30-year gilts have reached levels not seen in 26 years. The 10-year bond yield is also at its highest since 2008. While rising yields and falling bond prices have become a common theme across global markets, the UK has been particularly hard-hit due to a combination of persistent inflation, high public debt, and lingering economic uncertainties. More striking than the rise in yields itself is the speed at which they have surged.

This episode not only underscores the vulnerabilities in the UK’s economic framework but also highlights the burden on policymakers to balance inflation control, fiscal responsibility, and economic growth. As the country grapples with evolving financial and economic dynamics, understanding why the UK has been disproportionately affected and what this signals for the future is crucial. 

An increase in the long-term gilt yields has led the yield curve – plotting the bond yield against their maturities – to steepen sharply. The dynamics behind the opposite ends of the yield curve are key to understanding its current movement. Typically, the short end of the yield curve reflects the Bank of England’s (BoE) interest rate decisions. Currently, British markets expect fewer interest rate cuts in 2025. On the other end of the yield curve, the long-term yields are driven by inflation expectations and broader economic fundamentals. In the UK, inflation remains stubbornly above target levels. Consequently, this has led investors to demand a higher premium to offset the risks of inflation, leading to higher long-term yields. The steepening yield curve signals growing uncertainty about the UK’s economic outlook.

Beyond persistent inflation, the state of the UK’s public finances is another major factor driving gilt yields higher. The potential of the current government to deliver on its fiscal policy goals is widely debated. Chancellor Reeves’ recent October Budget risks inflationary pressures while significantly increasing government borrowing. As per the Office for Budget Responsibility, the budget aims to increase borrowing by £19.6 billion this year and by an average of £32.3 billion over the next five years. This additional borrowing will be financed by issuing new gilts. An increased supply of gilts typically lowers their prices and drives yields higher. The current sell-off also suggests that investors demand less of the gilts already on the market, which drives their prices down and yields up. What this means is that the government's borrowing cost goes up. Higher borrowing costs take away from the fiscal headroom to which the government committed. 

The budget also increases employment costs by raising wages and employers’ National Insurance contributions. This is backed by the government’s aim to fund its day-to-day spending from taxes rather than borrowing. However, tax revenues are unlikely to match the proposed rise in spending, at least in the short term. This mismatch creates a fiscal gap that exacerbates borrowing pressures. Furthermore, the delay in realising tax revenue adds to the immediate strain on public finances and increases the burden on gilt markets. 

The UK’s sluggish GDP growth adds to concerns about the economy’s ability to handle higher borrowing costs. Weak growth, coupled with high inflation and elevated gilt yields, raises the spectre of ‘stagflation’. This underscores the need for careful coordination between fiscal and monetary policies to avoid prolonged economic challenges. These concerns are mirrored in the depreciation of the pound. While, in theory, rising yields should attract foreign investors and strengthen the currency, the pound has weakened due to doubts about the UK’s economic resilience. A weaker pound increases the cost of imports. This adds to inflationary pressures and complicates the BoE’s efforts to stabilise the economy.

International uncertainties further compound the UK’s challenges. For instance, Donald Trump's return to the White House, with his proposed tax cuts and tariffs, could disrupt global supply chains and raise production costs. Such policies might keep US bond yields high, influencing bond yields in other countries, including the UK. These global factors make it harder for the UK to isolate its bond market from broader economic turbulence.

With the government planning to run large deficits, questions about fiscal sustainability have come to the forefront. While the UK’s current growth outlook appears bleak, there is some hope that increased public spending could stimulate economic activity in the coming years. However, this hinges on the government’s ability to execute its plans effectively and avoid further spooking financial markets.

The global bond sell-off and rising gilt yields have triggered widespread anxiety. However, for the UK, the spotlight is firmly on its economic growth and inflation trajectory. The BoE faces a difficult path ahead as its policies must navigate the delicate balance between controlling inflation and supporting economic growth. Meanwhile, the government must balance short-term fiscal stimulus with long-term sustainability. Ultimately, the reaction of financial markets and the broader economy will determine the success of these policies. The UK’s ability to overcome these challenges will depend on clear communication, prudent fiscal management, and coordination between monetary and fiscal authorities.

The views and opinions expressed in this article belong solely to the writer and do not necessarily reflect the views and opinions of the Warwick Economics Summit.

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