Job security at 10 Downing Street is at a low following the local election rout for Labour last month. The prime minister is under pressure to step down after his party lost nearly 1,500 council seats across the country.
As we wait for a by-election in Makerfield to see if Andy Burnham can win a seat in the House of Commons, he, Wes Streeting and Angela Rayner are seen as the front runners to challenge Keir Starmer. None of this turmoil has been good for UK bond markets.
A confluence of factors affecting UK bonds
And it comes at a time when global bond yields have coincidentally surged due to the conflict in the Middle East and rising inflation. UK gilts are under pressure on multiple fronts: a rising political risk premium; a deteriorating fiscal backdrop; heightened sensitivity to this global energy shock accompanied by stagnating economic growth; and finally, a wave of inflation that has seen UK consumers lose more than a quarter of their purchasing power since 2021.
At the height of the unrest, gilt yields rose to their highest levels since 2007, with the 10-year yield reaching 5.17 per cent. The pound fell 2.2 per cent against the US dollar. That has since settled a little, with the 10-year yield back at 4.85 per cent. Shorter maturity gilts proved to be more resilient. The Bloomberg UK Gilt 1-5 Year Index was down only 0.5 per cent year-to-date.
Markets pivot from pricing in rate drops to rate hikes
Even though they have recovered a little, with yields still high, it is hard to envisage a negative return from here on a one-year view. Back in March, when the US/Iran war had just started, markets were pricing in two interest rate drops this year.
By early May, that had swung to at least three rate hikes by March 2027. This pessimism has levelled off a little, to less than two hikes by March 2027, partly in response to the negative growth outlook for the UK and factors such as the reduction in consumer purchasing power.
As such, the Bank of England is likely to remain on hold regarding interest rates, with any near-term rate hikes potentially risking a policy mistake. And a sustained further rise in yields appears unlikely without renewed inflation pressure — the current pricing leaves scope for a rally should the outlook shift or inflation concerns ease.
How higher bond yields could impact the economy
Should bond yields start to rise again, given the shaky geopolitical and economic backdrop, the question is how high can they go and what would be the impact on the UK economy?
Economist Stephen Jen outlines three potential downside scenarios over the next three years, based on both the magnitude and persistence of higher gilt yields. While a framework like this is useful, the transmission of yields into the broader economy is complex and by no means cut and dried.
These scenarios are deliberately bearish and do not fully account for any stabilising forces that might prevail. They ignore the old adage that the cure to high prices is high prices — high prices destroy demand which in turn reduces the inflationary impulse that facilitates lower bond yields. The scenarios are:
Scenario one: stagnation
A persistent 1 per cent increase in yields (approximately what we have seen since the end of February) results in a prolonged period of stagnant growth. Mortgage rates rise by around 0.75 per cent and remain elevated, gradually weighing on the housing market, leading to an approximate 7 per cent decline by 2029. Sterling weakens, with GBP depreciating by around 4 per cent.
Scenario two: recession
A persistent 2 per cent yield shock (more than 1 per cent rise from here) pushes the economy into recession, shrinking by 3.2 per cent over the three years. Mortgage rates rise by around 1.5 per cent. Housing market weakness becomes more pronounced, declining more than 13 per cent. GBP depreciates by 7 per cent to 8 per cent versus the dollar. This scenario would also create significant fiscal stress for the UK government.
Scenario three: deep recession
Under a persistent 3 per cent yield shock, the economy enters a severe recession contracting by more than 5 per cent over three years. Mortgage rates rise by approximately 2.3 per cent, remaining structurally higher throughout the period, while house prices fall close to 20 per cent by the end of 2029. GBP/USD declines towards 1.20 (currently at 1.33). This scenario would also present a major fiscal crisis for the UK government.
Central banks could step in
These scenarios will not necessarily play out. Policymakers retain the tools required to support the market if necessary.
For one, the BoE could halt active quantitative tightening (a contractionary monetary policy used by central banks to reduce the money supply), stabilise prices and shrink their bloated balance sheets. The Debt Management Office will likely focus on shorter dated issuance, which would reduce the government’s borrowing costs and limit the risks at the most vulnerable point on the yield curve (the long end).
What we think will happen
Our base case is for the BoE to remain on hold for the time being; they may raise rates in Q2 or Q3 once, but this is likely to be a policy error. While the bond market might be vulnerable at the moment, we do not believe a further rise in yields will be particularly persistent given the implications for the economy.
Nonetheless it is important to understand the potential economic implications for a further and persistent deterioration in the UK bond market so the appropriate measures can be put in place should the worse happen.
Tom Hibbert is the chief investment strategist at Canaccord Wealth
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