What’s happening with the UK Government bond market

The first Budget from a Labour government in 14 years continues to stir heated debate and sceptics point to the increase in the yield in the UK’s 10-year gilt to a one-year high to support their case that Chancellor Rachel Reeves is on the wrong track.

It doesn’t look great that yields are rising in the wake of August’s interest rate cut from the Bank of England, but 10-year government bond yields are rising in France and the US, too, and faster than they are here in the UK, to perhaps suggest there is a wider issue at work.

In principle, the price of benchmark government bonds should rise and the yield should fall once a central bank cuts interest rates, especially if the monetary authorities give strong hints that further reductions in headline borrowing costs are on the way.

This is because the coupons on existing issue may look more attractive relative to the coupons that will come with newly issued bonds, so investors will look to buy the bonds that are already available to lock in higher returns (at least in nominal terms). The price of existing benchmark bonds, such as those with a 10-year maturity, should rise and so the yield should fall, since the coupon payments continue to come at their pre-set level at the pre-set time.

However, the yield on the 10-year UK gilt is now 48 basis points higher than on 31 July, the day before the Bank of England sanctioned a one-quarter percentage point interest rate cut, the first reduction in headline borrowing rates since 2020.

Source: LSEG Refinitiv data

At 4.45%, the 10-year gilt yield is as high as it was during the peak of autumn 2022’s Trussonomics panic, although the rate of rise has been gentler and it must also be remembered that the Bank of England base rate now is 5%, compared to 2.25% two years ago, so the comparison is not an entirely fair one.

In addition, yields on 10-year bonds are also rising in Germany, France and the US, so the UK is not alone in seeing this increase. The European Central Bank has pushed through three interest rate cuts and the US Federal Reserve one (a bigger, half a percent move).

Stock markets cheered this pivot to looser monetary policy, as evidenced by how headline indices such as the S&P 500 and NASDAQ Composite in the US, DAX and MIB-30 in Europe and even the benighted FTSE 100 trade at or very close to multi-year or even all-time highs. By contrast, bond investors have not embraced lower interest rates.

Chancellor Reeves may take some comfort from how the benchmark UK 10-year gilt yield is up by less than the yield on 10-year US Treasuries in absolute terms, and by less than the change in 10-year French OATs relative to the decline in headline interest rates, as Britain is not being singled out for treatment from bond vigilantes.

Source: LSEG Refinitiv data

However, from an investment point of view, the wider uncertainty across sovereign debt markets is a potentially troubling sign, especially as stock markets remain buoyant and investment grade corporate debt markets offer what look like low spreads (premium yields) relative to government issue.

It may be no coincidence that the UK, France and the US have sovereign debt positions that are attracting greater scrutiny.

France’s new prime minister, Michel Barnier, is trying to push through tax increases. Britain’s new Chancellor is changing the rules, increasing taxes and trying to engineer growth to help the UK salt down its debt-to-GDP ratio and interest bill. And nerves are jangling in the US as neither candidate has spoken of the deficit as an issue during the lengthy campaign, and instead offered policies which would increase the deficit even faster than current Congressional Budget Office predictions.

Lofty interest bills – a fifth of the total tax take in the US – could persuade central banks to keep rates lower than they might otherwise, as governments can ill afford to refinance at higher rates. Austerity will simply see politicians ejected from office at the first possible opportunity, so they may have to take their chances with inflation.

Source: FRED – St. Louis Federal Reserve database

That is one potentially large spanner in the works, so far as the narrative of cooling inflation, a soft economic landing and lower rates is concerned, and it is that narrative which is doing much to carry stock markets to their current lofty levels.

The Volatility index, the VIX or fear index, that measures expected volatility in US stock markets is back above 20. While this really only leaves it in line with historic norms, this is a higher figure by recent standards and suggests that someone, somewhere is becoming more nervous than headline share indices would imply. The Volatility of Volatility Index, or VVIX, and the price of options on the VIX (and effectively portfolio insurance against a wider market upset) are also on the rise.

The Bank of America MOVE index, which tracks volatility in the US Treasury markets, stands near a one-year high, while the CBOE OVX measure of oil market volatility is also elevated at 44, against its historic average reading of 37.

Source: Investing.com, CBOE

This could just be a case of jitters ahead of the fiercely contested US presidential election, especially as the war in Ukraine continues and tensions in the Middle East remain elevated.

But it could also be a signal that the rapid stock market recovery in the wake of Covid-19, the Russian assault on Ukraine in 2022 and then the American banking crisis of spring 2023 could be about to enter choppier waters. The sharp rise in the price of gold to an all-time high could be seen as a further warning to prepare for a less clear-cut outcome than the one stock markets expect when it comes to lower inflation, steady economic growth and lower interest rates from central banks.