Government bonds sell off, what is happening?

On Wednesday UK government bond yields rose to their highest levels since 2008¹. Usually, the pound would rise with gilt yields, but this relationship has broken down and this morning the pound fell to a 14-month low versus the US dollar amid concerns over the country’s finances and a strong US currency². 

The higher bond yields could make it more expensive for the government to borrow money. This would have a direct impact on the government’s spending plans announced in the October 2024 budget and increase the risk that the government will breach their fiscal rules and either announce further tax rises or spending cuts. The weaker currency, should it persist, will likely add to inflationary pressures through higher import costs. 

The Treasury has confirmed its commitment to the government’s fiscal rules to calm and reassure markets. 

There’s a concern that this current sell-off echoes the one that took place in August-September 2022. Bond markets were spooked by Kwasi Kwarteng’s, the then Chancellor of the Exchequer, mini budget which introduced billions of pounds of tax cuts. The yields on the UK 10-year government bond rose from 3.49% on the eve of the budget to peak at 4.5% less than a week later. This time the yield has risen from 3.75% in September 2024 to 4.8% and there has been an interest rate cut in this time¹.   

The backdrop for the mini budget was markedly different from the current situation.  Inflation was still elevated with the Consumer Prices Index (CPI) at 10.1% and interest rates were at 2.25%. Both were still rising. Now inflation is down to 2.6% (as of November 2024) and, after peaking at 5.25%, interest rates have been cut to 4.75%¹.

The crucial difference is the 2024 budget spending plans have been fully costed through tax rises and increased borrowing. Markets did not panic when the plans were announced, but they did after the 2022 mini budget. 

Some may frame this as a UK-specific issue, but the reality is that the bond market sell-off has been triggered by other factors too. 

In particular, US bond investor concerns are affecting other government bond markets. In the US there are two views, which support the case for higher bond yields. Firstly, the optimistic side of the argument is the US is heading to a period of stronger growth which means that interest rates are less likely to fall as quickly as had been forecast.

Secondly, other bond investors are concerned that the incoming President, Donald Trump, will drive borrowing levels even higher and these investors want a higher yield in return for the increased risks that come with a higher level of debt. 

The bond market has a reputation as a forecaster of economic conditions, such as future economic growth or interest rates. 

While the bond market doesn't always get it right, in the short term this can impact sentiment and weigh on investor confidence. For example, this sell-off coincided with investors taking money out of the large US technology stocks, some of which had achieved new all-time highs earlier in the week, on concerns over elevated valuations.

In the longer term, the higher yields could lead to more expensive borrowing costs and impact growth.   

So, what does this all mean for investors? Overall, the UK market has been affected more as the higher yields could directly impact Chancellor of the Exchequer, Rachel Reeves’ borrowing plans, which she announced in 2024. 

Meanwhile, the US market has not been affected as drastically as it benefits from its position as the world’s largest economy and because the US dollar is the world’s reserve currency. 

Some investors are selling UK government bonds as confidence in the government’s ability to tame inflation and grow the economy wanes. But while there is a loss in confidence, the likelihood of the UK defaulting on its debt obligations is still slim. 

While we remain positive on global growth and prefer equities, bonds continue to offer diversification for investors and provide an income. Following the recent falls, government bond yields are now higher.

Ultimately, the increase in government bond yields is still concerning and this is a central risk to our view as it could impact longer term growth.  

We continue to monitor the situation closely and will adjust our views to take advantage of opportunities and protect portfolios accordingly

1. LSEG Datastream
2. MSN.com; Pound slides to 14-month low as gilt pain intensifies, 9 January 2025