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The gilt market suffered a brutal sell-off on Friday as war in the Middle East stoked inflation fears, sending the UK’s borrowing costs spiralling higher and putting pressure back on the public finances.
The yield on 10-year gilts surged as much as 0.19 percentage points to 4.73 per cent as their price slumped, underperforming other big debt markets.
The yield was later up 0.14 percentage points on the day, and up more than 0.4 points for the week, its biggest weekly jump since the ill-fated “mini” Budget in 2022.
Hopes for Bank of England rate cuts have faded in the face of soaring oil and gas prices, with 0.13 percentage points of rate cuts priced in for this year by the market currently, compared with more than 0.5 percentage points at the end of last week.
The moves were “a bit eye-watering”, said Sanjay Raja, chief UK economist at Deutsche Bank.
“One of the most high-conviction trades going into the end of last week was still UK [gilts] . . . all those positions are being unwound at the moment,” he added.
Market participants attributed the sharpness of the UK sell-off to a forced unwinding of such trades, including so-called steepeners — those that had bet short-term gilts would outperform longer-term debt.
One investor called it “a huge consensus positioning stop-out”, referring to traders having to exit lossmaking positions.
“Gilts had outperformed ahead of this, which suggests position squaring is playing a part,” said John Stopford, head of multi-asset income at asset manager Ninety One.
Investors were “worrying about an extended conflict, but a protracted war still seems a tail risk rather than the central scenario”, he added.
Reinout De Bock, head of European rates strategy at UBS, said a positive view of gilts was one of the bank’s “top trades” going into this year. “We have been very bullish on the UK,” but “we will be assessing this” on the basis of the energy prices, he added.
The price of Brent crude, the international oil benchmark, has risen more than 25 per cent since the US and Israel attacked Iran last weekend, trading above $90 a barrel for the first time in nearly two years. European gas prices have soared more than 60 per cent in the past week.
Gilts have been especially vulnerable in the global bond sell-off because the BoE had been expected to cut interest rates more aggressively than central banks in other big economies such as the Eurozone.
Economists at the National Institute of Economic and Social Research warned that if the oil and gas price surge was sustained, it may not only mean BoE rate cuts are off the agenda but it could also force the central bank to raise rates above 4 per cent from 3.75 per cent currently.
Rob Wood, UK economist at Pantheon Macroeconomics, said the UK inflation rate, which the BoE was last month predicting would fall to its 2 per cent target in April, is now no longer likely to drop below 2.5 per cent if energy prices stay where they are. A re-acceleration to more than 3 per cent was possible in the second half of the year, he added.
Consumer price inflation was 3 per cent in January.
For chancellor Rachel Reeves, the moves in gilts come as a serious blow after she championed her efforts to bring “stability” to the public finance in her spring economic statement on Tuesday.
The chancellor has built her so-called budget “headroom” against the key UK fiscal rule to more than £23bn, providing her with a buffer against adverse moves in gilt yields.
But the energy surge will raise fears that the Treasury will need to intervene to cushion the blow to consumers from rising prices, adding to pressure on the public finances, analysts warned.
The most obvious step would be to cancel plans to begin increasing fuel duty starting in September. Wood said this by itself would not be overly costly, but added that the exchequer faced other looming pressures, including the fiscal costs that could stem from a reduction in immigration forecast by the UK watchdog, the Office for Budget Responsibility.
“The headroom is still trivial relative to the total numbers on UK government spending and taxation,” he said. “Even relatively small changes can wipe out that headroom.”