American novelist Ernest Hemmingway coined the phrase ‘gradually then suddenly’ in his 1926 Novel The Sun also Rises, and that seems an appropriate description of investor’s reaction to rising bond yields.

UK 10-year bond yields sit just shy of 5% compared with close to 4% in the middle of October, to reach their highest level since October 2007, on the eve of the financial crisis. This is higher than the spike during the disastrous Liz Truss mini Budget in September 2022.

It would be wrong to label the current rise in yields as apurely UK phenomenon as the same trend has unfolded to varying degrees across US and European bond markets. What does it mean and why is it happening?

Investors seemed unfazed by the rise in yields at the back end of 2024, but suddenly they are worried. This can be seen in the sharp underperformance of small- and mid-cap companies due to their greater sensitivity to higher costs of borrowing.

Over the last month the FTSE 250 index has dropped almost 6% compared with a 1% fall in the blue-chip FTSE 100 index. It is the same story across the pond where the small cap Russell 2000 index has lost around 8% compared with a 4% fall in the S&P 500.

The why is harder to fathom. US bond markets tend to have a big influence on global bond markets, so that is a good place to start looking for answers. The December Federal Reserve meeting has changed the rate outlook substantially.

The Fed’s latest summary of economic projections saw the number of rate cuts halve to two this year from the four expected in September. Markets subsequently repriced expectations for the US rates upwards to around 4% in 2025 from under 3%.

Not helping matters, December’s non-farm payrolls (10 January) surprised to the upside by a wide margin with 256,000 jobs created compared with 165,000 expected, suggesting the US economy remains resilient.

Any suggestion that sticky inflation is pushing up interest rates does not chime with measures of medium-term inflation expectations which appear well anchored around 2.4%.

That said, it is worth investors keeping an eye of services inflation which has remained elevated relative to producer prices.

The most likely explanation for rising bond yields in recent weeks is investors demanding higher long term interest rates to compensate for greater uncertainty.

Uncertainties around president-elect Donald Trump’s economic measures, wide budget deficits being run by the US, UK and European governments and the high and rising levels of national debts are all causes of concern for bond investors.

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