The Long View: How bad could it get for Gilts and what does it mean for sterling and UK equities?

In its July 2025 report, the Office for Budget Responsibility, said: “The UK’s public finances have emerged from a series of major global economic shocks in a relatively vulnerable position.”  At the end of 2024, the UK government’s deficit stood at 5.7 per cent of GDP, around 4 percentage points higher than the advanced-economy average.

The OBR notes that the UK “has seen a sharper rise in the costs of servicing its debt than other G7 economies”. Since early 2023, the yield on the UK 30yr gilt has risen by a rough 200bps, vs a 100bps for the US and German equivalents.

Recent moves in the bond markets make this situation worse as higher interest payments eat into taxation.

The question for UK investors is what happens to gilts next, and what could be the read-across for sterling and UK equities?

Firstly, the UK is not alone, albeit we have seen the spread between UK 10yr gilts and those of peers open up to record highs. Global bond yields are moving higher on a broad mix of investor concerns about the sustainability of debt dynamics, inflationary fiscal policy, higher defence spending, uncertainty over the path of tariff policy, political chaos in France, expectations for higher issuance of debt and lower demand, and a range of idiosyncratic factors in each region.

Teasing out the local from the global is tricky – was this week’s move in bonds down to the court ruling in the US, which said most of Trump’s tariffs were illegal, sparking the selloff because investors worry about the implications to how much money the government can raise? Or was it centred on the French political situation, which is likely to see the third government fall in little over a year over a budget impasse relating to fiscal consolidation? Or was it political moves in the UK casting a shadow of the upcoming Budget, slated for November 26th?

We should note that Tuesday saw US market makers return to the fold after a holiday and the biggest day for bond issuance ever in Europe, while Britain’s syndicated sale yesterday and linker tomorrow also constitutes record issuance. So a flood of issuance maybe made these moves stronger than they may have been – but still reflect a problem with issuance being high.

UK: An outlier?

For the UK, two sets of recent developments have cast the fragility of its debt and fiscal situation into sharper relief. One is the constant, unabating stream of possible tax policies being floated in the press, which serves to reduce confidence in the market that the government really has a plan. If it had a plan, bond vigilantes are saying, it would be hammering the message home day in, day out by now. 

Two, Starmer’s poaching of Reeves's chief lieutenant undermines her credibility and that of No11 – she looks sidelined. The market wobbled after the Chancellor looked in trouble following the Welfare revolt and breathed a sigh of relief when it looked like Reeves was staying put – the reaction in gilts this week is indicative of concerns that anyone else will loosen fiscal rules.

Looming behind these short-term factors is the UK’s twin deficits, low nominal growth and zero productivity growth. We’ve also suffered by having more persistently high inflation than G7 peers, which has reduced the scope of the Bank of England to lower short-term rates. Many of the reasons for the inflation, it should be noted, are due to government policy – energy pricing, payrolls taxes and so on. 

Indeed, energy pricing is a key policy lever to pull on which would reduce interest rates and boost growth.

Markets are clearly seeing a chance the Chancellor (or No10) loosen fiscal rules – ie open up the taps to borrow more. The reaction in sterling is also a function of markets worrying that the only way to balance the books is to raise taxes further, squeezing growth and the tax take in a negative feedback loop. So, it's two-fold concern about the remedy - one is more borrowing, which bond vigilantes are punishing, combined with a fear that if you don't do that you have to squeeze productive earners and businesses. Worse, you do both because you cannot stop spending. The UK faces an acute problem – raise taxes and enact austerity and you might get the debt markets on side briefly but longer term does this really improve the deficit trajectory if the economy shrinks relative to the debt? This will be important for how the market views sterling.

And every time rates rise on the money markets, the government's tiny fiscal headroom is reduced still further in a vicious cycle. The UK is near the debt-trap scenario where growth is below the rate at which it borrows, which means the debt keeps growing. 

Whilst easy to lay blame on economic and fiscal policy mistakes, we should not ignore certain idiosyncratic factors that are not really about doom loops, per se. Defined benefit pensions schemes are winding down, which means they buy a lot less long-dated paper. Total pension scheme holdings of gilts as a share of GDP are projected to fall by 18.6 percentage points from 29.5 per cent of GDP in 2024-25 to 10.9 per cent of GDP in the early 2070s, says the OBR. This will produce a structural weakness in demand and may be reflected in the UK’s higher borrowing costs.

The fiscal rules themselves are clearly a problem, as well, creating an artificial cliff-edge that a) requires a response and b) means the response is wrong.  

On our fiscal deficit – we have the highest among advanced economies at 5.3%, except for the US (6.6%) and France (5.4%). But the US has the reserve currency and France has the ECB backstop combined with the fiscal power of Germany. 

Another factor is defence spending. This is not peculiar to the UK, but it’s one of the reasons why global bond yields have moved higher this year. Markets are betting that advanced economies are in a new, protracted phase of spending commitments that they won’t be able to finance without raising more debt. Unlike Germany, Britain does not enter this new paradigm in good shape on the fiscal side with debt at about 100% of GDP. We are now in a new era where fiscal (government) drives the economic agenda, not monetary policy. In the US this is playing out with the Fed looking increasingly like it will be subordinate to the Treasury – an era of fiscal dominance that will see the market demand higher premia. 

While not unique among advanced economies, it's an ugly, ugly situation for the UK - the fiscal doom loop as some call it - and one that can lead to a fiscal crisis or event where we see a material blowout in gilt yields - communication from the government will need to seriously improve in the next few weeks to avoid a market event unfolding. 

So how can they communicate better? First would be to create more headroom from year to year – Rachel Reeves needs to give herself more space – you can’t be constantly tweaking tax rates to meet arbitrary rules. The market ought respond to this well – it would anticipate that the government is taking charge of the situation rather than being buffeted by fractional changes in GDP and tax take. It could respond badly if it thinks this is used to cover more net borrowing – the key is in the communication and presentation of the policy.  

There is not a lot Reeves can do about global bond moves driven by the US, Japan and Europe. Nor can she force DB pension schemes to load up on more gilts (in fact the problem is more about pension schemes not buying enough equities...you can’t have it both ways). But the government could get rid of its Net Zero obsession – UK energy costs are far higher than peers and are a big lever to pull in terms of trend growth and would lower market interest rates materially by driving productivity gains across the economy. It could also target the triple-lock, by saying it will take steps to control this cost.

The Bank of England can help – dialling back or stopping quantitative tightening, for instance. Issuing less long-term debt might be another given the problem in the market is with the long end – why borrow 30yr paper at 5.7% when the 2yr is at 4%? Average gilt maturity is around 14 years, double that of peers, while the average rate of interest stands at about 3.9%. this could be reduced by careful coordination of the Debt Management Office and Treasury.

Without a clear, coherent policy to use monetary policy tools, alongside fiscal probity and a communication strategy to markets about what is required, the situation for gilts could get a lot worse before it gets better.

Cross-Asset Look

It’s important to be aware of some of the correlations affecting these different asset classes.

Higher bond yields affects companies differently. For instance, so-called bond proxies such as utilities include the likes of National Grid and SSE, which have fallen as bond yields rose. Long duration stocks – ie growth names – tend to underperform value sectors. A steeper yield should benefit banks and insurers but worries about the state of the UK economy act as a counterweight to this when rates are rising for the ‘wrong’ reasons (ie not on stronger growth forecasts but for the reasons discussed at length above).

Rising long-end bond yields also reflect expectations for more persistently higher inflation, which has been supportive of precious metals and the miners that dig them up, such as Fresnillo and Endeavour. Other mining stocks could benefit from expectations for inflation pushing up the price of ‘real assets’ like iron ore and copper, but global growth dynamics and demand from China and the US is probably more important here.

Domestic stocks in the FTSE 250 tend to import goods so a weak currency is a negative, while the export-led FTSE 100 stocks earn in dollars so the translation effect is positive.

Where next?

• Gilts face long-term domestic structural headwinds as well as short-term fiscal worries amid a global selloff in longer-dated debt - however the Chancellor has an opportunity to assuage market worries by the right mix of policy and communication

• Sterling remains susceptible as rising gilt yields is negative for the currency, whilst efforts to control the ‘bond vigilantes’ and lower market rates would be negative for the economy

• UK equities are exposed to these cross-currents – domestic stocks have suffered due to concerns about consumer demand and growth, whilst the internationally- oriented FTSE 100 looks more insulated