As the inflation shock from the Middle East conflict rips through global bond markets, the sell-off in gilts stands out for its scale and swiftness.
UK 10-year borrowing costs soared to an 18-year high of 5 per cent on Friday, capping a rise of 0.78 percentage points since the Iran war began.
The rout in shorter-term government debt has been even more brutal. The market is on course for the worst month since the 2022 crisis that followed the ill-fated “mini” Budget, undermining chancellor Rachel Reeves’ claim this month that she had brought “stability” to the economy.
This jump in the government’s borrowing costs, which feeds through to significantly higher cost of debt for businesses and households — with mortgage deals also being pulled at their fastest pace since 2022 — has not been matched by other major markets. The corresponding rate on 10-year German Bunds is up 0.41 percentage points, while US benchmark borrowing costs have climbed 0.37 percentage points.
So in a global energy shock, why are the bond vigilantes targeting the UK in particular?
The UK’s energy vulnerability
One reason gilts have suffered more than other big bond markets such as US Treasuries is the greater vulnerability of the economy to a rise in oil and gas prices. Natural gas made up about 35 per cent of total energy demand in 2024, heating the vast majority of UK homes. By contrast, Europe relies on gas for only about one-fifth of its energy mix.
The US is far better insulated, having established itself in recent years as a major energy exporter. That is why traders have been betting that the UK will be more vulnerable to a rise in imported inflation: UK one-year inflation expectations have risen 1.8 percentage points, since the conflict began, a bigger increase than the US or euro area.
Inflation is kryptonite to bonds as it erodes the value of the fixed cash flows they offer and pushes central banks to increase interest rates, a shift in expectations that also forces bond yields higher.
Inflation was already relatively high in the UK ahead of the conflict at 3 per cent, compared with 1.9 per cent in the euro area. So the shift higher as oil and gas prices surge — with Brent crude jumping above $100 a barrel — is from a higher base, so demands a quicker response.
Interest rate optimism has evaporated
The UK’s persistent inflation is a reason why the Bank of England’s interest rate is at 3.75 per cent, compared with 2 per cent in the Eurozone, and why UK borrowing costs were already the highest in the G7 before war erupted in the Middle East.
But UK inflation has been gradually falling over the past year, and traders came into the conflict expecting two quarter-point rate cuts by the BoE this year — more than for some other big central banks — in a bet that it would act to support a weak economy as wage pressures faded. Big investors were betting that a gilts rally since November’s Budget, which also eased some concerns about the UK’s daunting borrowing needs, would continue with the help of those interest rate cuts.
Surging energy prices have led to those bets evaporating, with the market shifting to anticipate three quarter-point rises to the BoE’s benchmark rate by the end of the year. The volte-face on rates was encouraged by the BoE itself, which on Thursday warned on inflation and opened the door to future rises even as it kept borrowing costs on hold.
The result was one of the “most violent sell-offs in history” for short-dated gilts on Thursday, according to Fidelity International fund manager Mike Riddell, with the two-year yield jumping 1 percentage point so far this month. “It’s hard to imagine that was the [BoE’s] desired impact.”
A playground for hedge funds
But the UK’s energy exposure — and the BoE’s response — do not on their own explain the violence of recent gilt moves, market participants say. Instead, many point to the popularity of the UK government bond market with speculative investors such as hedge funds.
The BoE has warned the growing influence of hedge funds has the potential to exacerbate swings in the gilt market, as such investors become a growing force in UK government debt.
Firms that had accumulated large bets on lower BoE interest rates in recent months rushed to ditch those bullish positions as the market moved against them, exacerbating the sell-off, analysts say.
Violent swings across financial markets have been painful for macro hedge funds. Caxton — which told the FT in November that there was a mispricing in UK yields and that borrowing costs could fall — was among those stung as yields and oil prices have spiralled higher.
Su Liu, head of sterling rates trading at Citi, said that “long-term holders are not rushing out and selling gilts” but that there had been a big bet on short-dated UK bonds from “speculative accounts” going into the conflict.
Thursday’s BoE meeting created a fresh wave of pain for traders who had piled back into gilts betting the sell-off in the early stages of the war was overdone.
“[The BoE] triggered a whole wave of stops from people who’d tried to take on the market a little bit and thought it had gone too far,” said Barclays strategist Moyeen Islam.
The pressure on public finances
With the UK’s debt pile close to 100 per cent of GDP, the UK already spends more than £100bn per year on interest payments.
Higher yields mean that everyday borrowing by the government — with £250bn of gilt sales planned for the current fiscal year — comes at a higher cost.
Market concerns over the UK’s heavy borrowing — which has been close to record levels in recent years — have hung over the Labour government since its first Budget in late 2024.
Now, investors are worried that measures to insulate UK consumers from the energy shock are going to make the picture even worse, eroding the £22bn of wriggle room Reeves had in the Spring Statement against her fiscal rules.
If investors become more concerned that those limits will be relaxed or broken, meaning higher debt issuance, they may push UK yields higher still in anticipation.
But some argue the BoE is unlikely to respond to a one-off rise in energy prices with a string of interest rate rises, given the threat to already anaemic growth. With the 10-year yield crossing 5 per cent for the first time since the global financial crisis, there is a level at which big investors will sense a bargain.
“At these considerably higher UK gilt yields, we are seeing more value,” said Paul Eitelman, global chief investment strategist at Russell Investments, on Friday.
Additional reporting by Emily Herbert and Rachel Rees