Market News

By James Hirai

(Bloomberg) -- UK markets tumbled, pushing bond yields to the highest in more than a decade, as jitters over persistent inflationary pressures spark unnerving comparisons with the 2022 gilt crisis.

Benchmark 10-year yields jumped as much as 12 basis points to 4.81%, the highest since August 2008. The pound fell against all of its Group-of-10 peers, slumping more than 1% versus the dollar, while domestic stocks fell. 

UK borrowing costs have already soared in recent days, pushing long-term debt costs to the highest since 1998. While the latest increases don’t yet mirror the scope of those seen two years ago when Liz Truss’s disastrous mini-budget prompted a buyers’ strike, the spreading discomfort has investors nervous and risks complicating the calculus for the government as it looks to finance its spending plans.

The inflation outlook prompted traders to pull back their expectations for the Bank of England to cut interest rates this year, and came as yields globally soar as markets weigh the impact of potential tariffs from US President-elect Donald Trump on prices.

“This isn’t a healthy move,” said Megum Muhic, a strategist at RBC. “General concerns surrounding debt sustainability, resurgence of inflation and potentially inflationary Trump policies are all contributing to the narrative.”

Thursday’s price action is particularly concerning for traders because a slump in the pound accompanied the rise in UK rates. Typically, higher yields boost the appeal of a currency, so a coordinated move lower indicates that investors are doubting the broader case for investing in the UK.

The pound fell as much as 1.3% to $1.2321, the lowest since April. Meanwhile, UK domestic shares tumbled, with the FTSE 250 mid-cap stock index heading for its worst two-day slump since August. Compared to their larger UK peers, these domestic-focused firms were heading for the worst week on a relative basis since October 2023.

“The rise in yields is a painful blow, and it looks like, rather than being given new funds to help drive growth, government departments will have to make further cuts,” said Chris Beauchamp, chief market analyst at IG Group. “UK stocks remain cheap, and for all the wrong reasons.”

Reeves Problems

That’s a growing headache for Chancellor of the Exchequer Rachel Reeves, who’s been looking to portray Labour as the party of financial discipline to attract international investment and bolster growth. That mission has already hit a snag with policies around employment and an increase to national insurance contributions labeled as inflationary.

Meanwhile, fiscal rules that Reeves wants the government to follow, including a non-negotiable commitment to avoid borrowing for day-to-day spending, are coming under increasing pressure as her £9.9 billion of headroom continues to dwindle.

“It looks like a small ‘Truss moment’ that could be amplified if investors start to price a more dovish BOE,” said Roberto Cobo Garcia, head of G10 FX strategy at BBVA.

Money markets are now pricing just one full quarter-point reduction this year, with an 80% chance of a second cut. That compares with Tuesday when two cuts were a lock and traders placed a 20% probability on a third reduction by year-end.

“Fiscal sustainability questions come to the fore again,” Lloyds strategists including head market insights of Sam Hill, wrote in a note. If yields keep rising, “the Chancellor is likely to come under pressure to outline an approach for restoring fiscal headroom.”

Relentless Rise

Traders are closely scrutinizing recent debt auctions for signs of stress as a result, though the higher yields created by the selloff are attracting buyers. The UK sold £4.25 billion ($5.3 billion) of five-year debt Wednesday, attracting three times more bids than the amount of securities available. Yields on UK five-year bonds rose to a fresh 15-month high after the sale.

The slide in bonds Wednesday was exacerbated by positioning as long positions in gilt futures were stopped out, according to traders. The gilt market has proved more volatile than other major bond markets in recent years, with investors often citing periods of poor liquidity. 

“January is famous for crushing positions in ways which don’t always make sense and I felt like long UK duration was a fairly popular position,” said James Athey, a portfolio manager at Marlborough Investment Management. “It wouldn’t surprise me to know that there is a lot of stop outs going on.”

The fact UK markets are once again at the epicenter of a rout invites comparisons to the gilt crisis two years ago. Rates on 30-year inflation-linked gilts on Wednesday exceeded 2% for the first time since September 2022. Back then, traders were grappling with the fallout from Truss’s disastrous mini-budget — a period that saw a fire-sale of these securities as pension funds faced a fraught liquidity crunch that ultimately necessitated central-bank intervention. 

Ignoring the spike higher in 2022, the yield on linkers last traded above 2% consistently in 2003. The DMO is set to sell £1 billion of those securities next week.

To be sure, much has changed since the 2022 crisis. The liability-driven investment strategies at the heart of the crisis must now hold larger cash buffers in order to reduce the chance of another liquidity crisis after an international regulatory effort. The BOE is also developing a repo facility which will allow these funds to raise cash in the event of future turbulence.

What Bloomberg Strategists Say....

“Concern that the UK’s autumn budget will stoke inflation has been rippling through to the markets, with two-year inflation breakevens now about 55 basis points higher since Chancellor Rachel Reeves presented her plan. Gilts will continue to underperform their regional peers in the months ahead.”

—Ven Ram, Cross-Assets Strategist, Dubai

More broadly, Chancellor Reeves’ courting of markets is very different from the fiscal proposals of the Truss administration, which caught investors off guard. Because of Reeves’ self-imposed fiscal rules, the government will likely need to raise taxes or reduce spending if yields remain at elevated levels. 

“While the speed and extent of the move higher in bond yields has not been anywhere near as violent as that witnessed following the Truss budget in 2022, the impact of higher rates on the economy, particularly via higher mortgage rates, is not to be underestimated,” said Matthew Ryan, head of market strategy at Ebury.

--With assistance from Alice Gledhill, Joshua Gaunt-Warner, Joe Easton and Michael Msika.

(Updates throughout.)