It’s been a rocky ride in government bond markets so far in 2025 and the start of the week saw yields rising further before improving inflation data in the US and UK calmed nerves
The UK has seen some of the most dramatic headlines over the moves in bond yields given worries over stagflation risks along with a spiral of higher borrowing costs erasing the little fiscal headroom the Chancellor has, meaning difficult decisions over further tax increases and spending cuts.
In the UK we have seen plenty of headlines, and not just in the financial media, over the notable increases in government bond yields, the reality is that bond yields have risen across developed markets in recent months, as investors reassess the outlook for inflation and growth. With diminishing prospects for interest rate cuts, bonds have repriced for a less benign backdrop. The US outlook, with the economy still strong and the potentially inflationary policies of Donald Trump around the corner, has changed notably over recent months, and with expectations for multiple rate cuts from the Federal Reserve in 2025 evaporating fast, it is no surprise that bond yields have risen.
UK bond yields have risen from 3.75% in mid-September and touched a 16 year high of 4.93% at the end of last week, but eased slightly this week after inflation data was released. In the US 10-year Treasury bonds were 3.61% in mid-September, and touched 4.79% earlier this week. In Germany, 10-year Bunds were at 2.03% as recently as early December but yielded 2.65% earlier this week. So, given the moves in bond yields are global, why the focus on the UK?
The UK appears to be in something of a tight spot, with persistent low economic growth and worries over sticky inflation, all against a backdrop of a government that appears to be very fiscally constrained, despite running a lower deficit than other countries, such as France or the USA. Given upcoming increases to national insurance contributions and the minimum wage, employment costs are rising, and investment and employment intentions are falling, with higher employment costs set to be passed on to consumers. These factors point to stickier inflation than elsewhere and mean the Bank of England is likely unable to cut rates further. Sluggish growth forecasts suggest the UK is unlikely to be able to grow its way out of these problems.
Higher bond yields mean the government’s fiscal headroom has evaporated, further souring the mood because this means the prospects for a painful sequel to October’s budget are increasing. The UK Gilt market is normally reliant on foreign buyers, the “kindness of strangers” as former Bank of England governor Mark Carney put it, so when the mood music around the UK is so negative, the risks of a buyers’ strike increases tensions. UK Chancellor Rachel Reeves faces some tough choices in the months ahead; in the near term the lower inflation data this week may calm markets but the narrative around stagflation, and limited fiscal scope to boost the economy remains, while memories of the 2022 mini-budget debacle are fresh in memories of market participants, politicians and the wider public.
The government is acutely aware of comparisons to the Liz Truss/Kwasi Kwarteng budget and their own political and economic credibility. The rise in bond yields, which as I said earlier is not exclusive to the UK, does create specific challenges for the UK government, because the ‘fiscal headroom’ of £9.9 billion in the budget last October was based on the lower borrowing costs (i.e. the level of government bond yields) at the time. With the increase in bond yields, to levels not seen since 2008 in the case of 10-year debt, and since 1998 in the case of 30-year debt, this fiscal headroom has evaporated given the rise in bond yields equates to around £10bn a year in additional debt servicing costs.
The UK government still has options, but their choices are tough in the context of the backdrop of nervous bond markets and rising stagflation risks. The 26th of March is going to be a key date – this is when the OBR will update their forecasts for growth, inflation and unemployment. Their growth forecast is likely to be revised down from the 2% forecast made last October, while inflation and unemployment may be revised higher. This will exacerbate the problem for the Chancellor, creating a ‘black hole’ in the public finances. This week, the Treasury and Chancellor have both reiterated that the fiscal rules are “non-negotiable”, with the Chancellor telling Parliament she is “absolutely committed” to the rules. Per last October’s budget, government spending will increase in the near term before fiscal tightening kicks in later in the Parliamentary term. Changing the fiscal rules is unlikely from a credibility standpoint, unless a crisis or recession forces their hand. Later this month the Chancellor will make a policy speech on economic growth but in March decisions will likely need to be made on spending and tax in addition to last October’s budget, which will be necessary to keep financial markets on side, but politically very hard to stomach.
December’s UK CPI data delivered some relief for the Chancellor coming in at 2.5% against 2.6% expected. Services inflation, which has been stubbornly high, eased significantly from 5.0% year on year in November to 4.4% in December, though this was driven by what are likely to be temporary drops in hotel and airline prices. With inflation expected to rise above 3% by April, thanks to easing energy deflation and government mandated price increases, the scope for the Bank of England to cut interest rates is uncertain, though markets are still pricing two rate cuts this year; with the base rate at 4.75% there is still room for the Bank to ease policy if they are confident inflationary pressures are not worsening.
We saw more evidence of the strong US economy last Friday, with the latest employment report surprising to the upside. The US created 256,000 jobs in December, well above the 165,000 expected. Employment grew every month in 2024 and has done so for the last 48 months in a row, which is a tie for the second longest run in history. The longest ever run was 113 months, which came to a screeching halt in 2020 when the pandemic hit. The unemployment rate ended the year at 4.1%, down from 4.2% in November and well below the historical average of 5.7%. Wage growth continued to outpace inflation, for the 19th consecutive month. The preceding 25 consecutive months of negative wage growth is likely a significant contributing factor as to why the Democrats lost the US election.
The US inflation data saw CPI rise to 2.9% year on year which was in line with expectations and up from 2.7% in November. Core inflation eased to 3.2% in December against 3.3% previously. The fact the headline data was in line and core inflation surprised to the downside saw both US equities and bonds rally as expectations for the first rate cut of the year, which had shifted as far out as September after the strong jobs report, moved to July. Markets are now pricing a 60% probability of a second cut in 2025; this was only 20% before the inflation data was published.
The narrative around the US economic backdrop – with strong employment data, inflation going in the right direction and economic growth above 2% for the year is quite a contrast to the UK right now. If the expectations for the US play out, a solid economy combined with easing inflation pressures and some rate cuts sounds like a ‘goldilocks’ type scenario. A budget deficit of over 6% has certainly helped the US economy sail smoothly through choppy waters. The UK government can look across the Atlantic in envy – such a significant deficit for the UK would likely be unforgivable in bond markets unless the government can shift the narrative and deliver a credible plan to put the UK on a more positive growth trajectory.
Source: Columbia Threadneedle Investments as at 17 January 2025
