A watershed reached?

UK gilt yields rose across the board this week on the back of concerns about renewed inflationary pressures, a slower-than-anticipated reduction in interest rates and an anemic outlook for economic growth in the country.

The upshot was a spike in UK borrowing costs, a sell-off in sterling and question marks over the ability of the UK government to increase spending without further tax raises. Thirty-year gilt yields reached 5.37% mid-week, higher than at any time since 1998; 10-year borrowing costs also climbed to their highest level since 2008.

Longer-dated US treasuries and German bunds have come under similar pressure in recent weeks, as did French government debt toward the end of 2024, as investors face up to future uncertainties—but the UK market has been particularly hard hit.

On January 7, the UK’s Debt Management Office sold £2.25 billion 30-year notes, with a yield of 5.19%. A further £4.25 billion in five-year bonds came to market the following day, marking the biggest auction of UK government debt in a decade.

Orla Garvey, Senior Fixed Income Portfolio Manager at Federated Hermes Limited, highlights a number of factors that contributed to this week’s gilt yield spike, not least a further strengthening of the US dollar and the additional sale of UK gilts to an already well-supplied market.

“This week’s gilt sell-off highlights the lingering fragility of the market following the government’s autumn budget, which saw the UK government overhaul its fiscal rules to ramp up public spending by £70 billion a year, and draws attention to fundamental challenges faced by many developed economy governments,” says Garvey.

“Weak economic growth is making it increasingly difficult to meet deficit targets, and this is eroding the already-limited fiscal headroom. In the UK, this leaves gilts vulnerable to elevated price fluctuations, where higher yields can dampen growth, leading to more borrowing needs and in turn even higher yields.” Compounding the issue is a deteriorating UK labour market coupled with pressure for increased wage growth. That raises the risk of either higher prices, in response to higher wage demands, or higher unemployment — “neither of which bodes well for gilts,” she says.

For John Sidawi, Senior Portfolio Manager, Federated Hermes, the volatility can be seen in the context of ballooning government debt across the world. He argues that the issue of fiscal expansion could rise to the top of investors’ concerns in 2025. “If 2024 was a year where global monetary policy was effectively spearheading valuations in both equity and fixed income markets, then this year fiscal initiatives should take over the driver’s seat. We believe global monetary policy could be poised to become more of a reaction function than a leading indicator.”