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UK gilts: the storm after the calm
The new Labour government promised economic stability and growth, but instead investor confidence in the UK gilt market has been hit in recent week. Neil Mehta, Investment Grade Portfolio Manager, highlights the structural forces affecting the UK economy and what recent market moves mean for investors.
Key takeaways
- The UK’s growth backdrop is deteriorating, with government finances challenged and inflation still not tamed.
- This has been reflected in higher volatility and lower liquidity in the gilt market.
- The risk premium the market attaches to UK assets could linger until a policy change.
A rocky start to the year
The yield on 30-year gilts soared to its highest level for over a quarter of a century a few weeks ago, with the rise in borrowing costs making front-page headlines.
While this recent rise in gilt yields can, to some extent, be attributed to external factors (such as US Treasury yields rising) and technical ones (new gilt issuance), structural forces continue to plague the UK economy, moderating growth but particularly on the inflation front.
A key driver of services inflation in the form of wages continues to move in the wrong direction, with the latest private sector wages at 6.0% year-on-year, the highest level since February 2024. Meanwhile, rent costs are rising by 8% per annum and proving to be sticky, while the impact of Chancellor Reeves’ hikes to employer national insurance is likely to push further cost pressures into inflation.
We are also approaching a key period for annual price increases across many utilities, with above inflation increases in water bills, council tax, energy bills and phone bills. Recent services PMIs highlighted that input cost inflation accelerated to an eight-month high, while a survey from the British Chamber of Commerce pointed towards a sharp slump in sentiment, with more than 50% of companies planning to raise prices over the coming months. This will add to the squeeze in consumer budgets.
No relief yet
Although disinflation has occurred recently, this is from high levels. The ‘sticky’ services part of inflation has fallen to 4.4% year-on-year, which is still not compatible with underlying inflation returning to 2% on a sustainable basis.
The ascent in bond yields has been more gradual than the ‘mini-budget’ under Liz Truss’ government in 2022, as investors wake up to the idea that the UK’s structural forces aren’t going away and the government has few options remaining. If taxes aren’t increased or spending isn’t cut further, we could continue to see these yields rise and risk premium gain further traction.
Gilt yields: higher for longer
Gilt investors are more paranoid since 2022 as it highlighted some key challenges the UK faces in terms of getting its finances in order in a higher interest rate environment. This is reflected in higher volatility and lower liquidity in the gilt market.
The risk premium the market attaches to UK assets could linger on for longer this time, given the government’s reluctance, as yet, to change course post last Autumn’s budget, which sparked the latest episode.
Given our pessimistic view on the inflation and growth backdrop, we think gilt yields will remain higher for longer, with the risk of markets coming to loggerheads with government policy. A day of reckoning for gilts could finally spark a change in policy direction in the coming months.
The Trump effect
Looking across the pond, Trump aims to unleash the US economy by implementing pro-growth policies around de-regulation, lower taxes, and lower energy prices. This could keep long end bond yields elevated and this has a knock-on effect on core rates markets, such as gilts. However, the key challenges are domestic on the inflation, growth and fiscal front.
Positioning
From an investment perspective, in our view, long end gilts still don’t fully reflect the risk premia attached to a challenging fiscal backdrop combined with persistent and elevated inflationary pressures. Prices (yields) would need to adjust lower (higher) to reflect the massive gross funding needs of the UK government, excess inflation, weak growth, higher deficit expectations, and rising political risk.
We still think the curve is ripe for further steepening. We are neutral gilts at these levels, but short GBP initiated before the budget and versus the dollar.
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