Gilt yields gap higher

We saw a sell-off across the UK Gilt curve on Wednesday with yields rising by 4bp at the short end and 11bp at the long end. This took the 10-year Gilt to 4.80% and the 30-year Gilt to 5.35%, with the latter bringing the unwelcome headline that UK borrowing costs are at their highest since the last century. The sell-off deepened on Thursday morning with the 10-year yield another 5bp higher at time of writing.

If we take a step back and look at the move over the last few months, the 10-year yield has risen more than 100bp from its low of 3.75% in September, but it is worth pointing out that this is nearly identical to the move of the 10-year US Treasury (UST) over the same timeframe. And so, it is fair to assume that the main driver of long end yields globally over the fourth quarter has been the easing of fears around labour markets, the well-documented ‘Trump trade’ and increasing nerves about the stickiness of inflation at current levels.

However, over the last couple of sessions Gilts have taken their own path and this has gathered attention across the market, perhaps especially because there seems to be a lack of “new news” driving the shift. The fact that sterling sold off at the same time also raised a few eyebrows.

What is behind these moves? One suggestion is that market participants have digested the UK’s inflation and growth data from the last few months of 2024; these were not overly encouraging with more stubborn inflation and weaker growth than many expected. The impact of this from a fiscal perspective is twofold. First, the Bank of England (BoE) might have to slow down its cutting cycle, thereby impacting the government’s future debt servicing costs as rates stay higher for longer. Second, the Office for Budget Responsibility’s (OBR) 2% growth forecast for 2025 – a key input for the fiscal headroom available to Chancellor Rachel Reeves – currently looks optimistic, and thus more borrowing might be needed to make up for the loss in tax revenues versus the forecast. Some other catalysts for the sell-off have also been mooted. One was a large block of gilt selling at around 11am on Wednesday which some believe was related to a £2bn tender offer from Annington Funding, along with the fact that the Gilt market is not always the most liquid government bond market in the world. Another was that 10-year Gilt yields were already trading near a closely watched technical level (their previous recent high of 4.75%), so pushing through this perhaps stopped out some large positions and the move took on its own momentum.

Looking forward then, one obvious indicator of how Gilts might trade is the UST curve, as the correlation between the two has been historically strong and bar the last couple of sessions this latest episode of volatility has been no exception. For us it is tough to see Gilts continuing to move higher if we saw a material move lower in UST yields. President Trump’s tweets aside, this is currently driven by data and the next test will be Friday’s US labour market data. The UK has important data releases of its own over the next couple of weeks in the form of CPI inflation and Average Weekly Earnings, where a close eye will be on services inflation which is still concerningly high at 5%.

If Gilt yields continue to rise from here, then in theory there are some levers that can be pulled. The BoE could pause its quantitative tightening or possibly even restart quantitative easing. The UK government could move to allay market fears with changes to spending or taxes. However, to be clear we do not see either of these interventions as imminent or likely at this stage. The government will want to resist changing policy just two months after its last Budget. For the BoE, market stability hasn’t been compromised and it will want to maintain credibility in regard to its mandate of getting inflation to 2%.

Significantly, this is different from the September 2022 Gilt crisis. The pace of change here has been 100bp higher in four months compared to the 150bp higher in less than a month back in 2022. The leveraged LDI strategies which exaggerated the move in 2022 have largely been unwound and reformed. And finally, headline inflation in the UK is now 2.6% compared to 10.1% in September 2022, and so general nervousness has naturally reduced.

We have not seen Gilts as a preferred risk-off instrument for a long time now. Political uncertainty and structural changes such as Brexit mean Gilts have not offered the predictability required. This is compounded by the issue of lower liquidity in the Gilt market compared to US Treasuries. And so, while our base case is that Gilts continue to trade weak over the coming period, our conviction is not high here and we continue to prefer watching from the sidelines.