Written by Laith Khalaf, head of investment analysis at AJ Bell
The bond market has taken fright from the growing sense of inflationary pressures in the air. The benchmark UK 10-year gilt has now risen to levels not seen since the financial crisis. It’s somewhat odd that bond yields have risen to new highs so long after interest rates have peaked, which suggests markets were complacent about inflation and overly confident that the Bank of England would cut rates sharply.
Rachel Reeves appears to be one potential culprit for rising bond yields, which is probably wide of the mark. Reeves’ maiden Budget was marginally inflationary, and did increase overall government borrowing, but since the beginning of October the US and UK 10-year bond yields have tracked upwards almost hand in hand (see chart below). Those who think the current bout of bond market jitters is down to policies announced in the Budget need to explain why there has been such correlation in the upward march of bond yields both here and in the US.
Source: Refinitiv, to 8 January 2025.
There are no easy answers to the question of why markets move, especially over a short time frame, and sometimes it’s simply a matter of momentum. However, the fact yields are rising on both sides of the Atlantic does suggest the new year has brought with it a focus on the incoming US president, and the potential for his trade and immigration policies to be inflationary, which has implications for both economies. Bond investors might also be looking at the giant stacks of government debt already on the books on both sides of the pond and saying thanks, but no thanks.
The US has the benefit or being the world’s reserve currency, which underpins demand for dollar denominated assets such as US Treasury bonds. Unless, that is, Donald Trump overachieves on his crypto goals and bitcoin becomes the world’s port of call for storing value (unlikely). Here in the UK higher yields put pressure on government finances and increase the risk that Reeves will come back with another tax raising Budget. A big saving grace is that the new chancellor has limited herself to one Budget per year, and so while we will get an updated set of forecasts from the OBR in March, which will lay bare the state of government finances, we don’t expect Reeves will have to balance the books though tax policies until the back end of the year. That gives plenty of time for the bond market to calm down, though that in turn will of course depend on whether global inflation actually rears its head again in 2025.
Such are the vagaries of short-term market movements, the current bond market sell-off could be a storm in a tea cup which dissipates quickly. Certainly, the US stock market seems pretty sanguine about rising bond yields judging by recent performance. Higher bond yields should hurt share prices by increasing the cost of company borrowing, thereby depressing profits, and also raising the opportunity cost of holding equities instead of bonds (of if you prefer, the risk-free rate). If higher yields get baked in, equity investors might start to question their exposure, especially in the US where the S&P 500 sits close to a record high and stock valuations are sufficiently high to leave little room for bad news.
It’s notable that rising interest rates caused a sell-off in the Magnificent Seven and the US stock market in 2022, a market fall that was largely brought to a halt by the public launch of Chat GPT, which precipitated a fresh bull run as investors eyed the prospect of a fresh wave of technological investment and productivity gains driven by artificial intelligence. Indeed, today the S&P 500 is 65% up on its 2022 low, a pretty staggering climb in just over two years.
It was Alan Greenspan’s interest rate hikes which brought the Dotcom boom to a crashing conclusion, and we shouldn’t underestimate the potential for rising bond yields to spark a stock market correction, if they remain elevated. That’s especially the case against a backdrop of lofty US equity valuations, high levels of concentration in a few mega-cap stocks, and the emergence of a step-change in technology which has the potential to both enhance and disrupt corporate profitability. If the bond sell-off fades away, then we’re probably back to the races.
Existing bond investors will be nursing some modest losses as a result of the latest sell-off. The typical gilt fund is down 2.5% in the last three months, while the typical pension lifestyling fund is down 4.4%, as these invest in longer dated bonds. To put this in some context, in 2022 these funds fell by 24% and 36% respectively. We’re very, very unlikely to see such deeply negative returns given yields are starting from a much higher level, and bonds are also now paying some income, which can offset capital losses.
Fresh bond investors might be licking their lips as yields rise and they are able to lock into higher rates. This is particularly the case for the band of canny short-dated low coupon bond investors, who have been using these bonds as a cash proxy to reduce their tax liabilities. If gilt prices continue to drop, an investment might fall into the red, but investors can still wait for maturity to simply collect the face value of the bond.
Rising yields also mean we are likely to see firmer pricing in the mortgage market, which will go down like a cup of cold cauliflower soup for anyone who is remortgaging or has decided to make the first giant leap onto the housing market. However it’s an ill wind that blows no one any good, and the corollary of this is that savers can expect fixed term cash deals to pick up again.”
