Rising bond yields, falling stocks, and a weakening pound are serving as a stark warning about the British economy and putting significant pressure on Keir Starmer’s Labour government.
While UK bond yields had been creeping higher in recent months, the market’s anxiety reached new levels this week. Long-standing concerns about inflation and Labour’s spending plans reached a breaking point, sending gilt yields to multi-decade highs. The 10-year yield surged to levels last seen in 2008, while the 30-year yield reached its highest point since 1998.
The situation was further complicated by similar economic concerns in the US, where the incoming administration of President Donald Trump has pledged to implement tax cuts and tariffs. These moves added to the turmoil in the UK markets.
The UK’s economic situation represents a worst-case scenario for investors: persistent inflation, rising government debt, and sluggish economic growth. The country, like much of Europe, also faces risks from Trump’s proposed tariffs, although some economists argue the UK may be less affected compared to other regions.
According to Marcus Jennings, a fixed income strategist at Schroders, the UK is experiencing a “negative feedback loop” where higher bond yields increase borrowing costs, which in turn worsens fiscal concerns. He noted that investors are particularly worried about the potential for stagflation, where rising inflation coincides with stagnant economic growth.
The market turmoil has also hit UK equities and the currency. The FTSE 250 Index, which tracks mid-cap companies, dropped 1.9%, marking its largest decline since August. Meanwhile, the British pound is nearing $1.23, its weakest level in 13 months.
The rise in bond yields is also creating challenges for government officials. Chancellor Rachel Reeves’ self-imposed fiscal rules may force her to raise taxes or cut spending if yields remain elevated, as these moves would be necessary to maintain fiscal discipline.
Neil Birrell, chief investment officer at Premier Miton Investors, compared the current market environment to the period around Liz Truss’ ill-fated budget in 2022, which caused a similar spike in bond yields. He warned that the current combination of tax increases and spending cuts may not lead to the growth the government is hoping for.
The rapid decline in bond prices this week occurred without any clear catalyst, highlighting the fragile sentiment in the markets. The simultaneous rise in bond yields and fall in the pound added to concerns, as higher yields typically boost currency values.
Mike Riddell, a portfolio manager at Fidelity International, cautioned that while there is no immediate sign of a crisis, the current situation could be an indication of a “buyer’s strike” and potential capital flight.
Traders are hopeful that the UK won’t experience a repeat of the 2022 market crisis sparked by Truss’ budget. Liability-driven investment strategies, which were at the heart of that crisis, are now required to hold larger cash buffers, reducing the risk of another liquidity crunch. Additionally, the Bank of England is developing a repo facility to help funds raise cash in times of market stress.
The current moves in the market are largely driven by positioning rather than fundamentals, with the high yields available in the UK attracting some investors. According to data from the Commodity Futures Trading Commission, sterling was the only currency among the Group of 10 that leveraged funds were net long against the dollar in the week ended Dec. 31.
Nonetheless, the fact that UK markets remain vulnerable to sudden swings is likely to deter international investors. Memories of the 2022 gilt crisis are still fresh, and many of the country’s economic challenges remain unresolved.
ING strategists, led by Michiel Tukker, pointed to a combination of factors driving the current market stress, including Labour’s spending plans, stubbornly high inflation, rising US interest rates, and supply pressures. They expect gilt yields to fall later in the year but warn that these factors may take time to dissipate.
