UK government bond yields have soared amid growing questions about who will lead Britain's government and the future direction of fiscal policy, after the ruling Labour Party suffered significant losses in local elections earlier in the month. Yields on 10-year and 30-year gilts rose to their highest levels in decades.

The gilt market endured a similar selloff in March when the disruption of oil and natural gas shipments through the Strait of Hormuz triggered fears of higher inflation. Yet on February 27, the day before the war in Iran started, yields on the 10-year gilt had reached a 15-month low.

Amid the turbulence, there are some surprising developments in the gilt market, and not all of them are negative, says David Curtin, an interest rates strategist in Goldman Sachs Global Banking & Markets. Banks and insurers are continuing to buy gilts and the government’s fiscal picture is sounder than during other recent episodes of volatility.

“There are pockets of demand that are quite positive,” says Curtin.

We spoke with Curtin about his outlook for the gilt market and how the Bank of England may adjust its policies.

Why have gilt yields risen?

It comes down to political uncertainty and how much term premium, the extra yield bondholders earn from longer-maturity bonds, you need to lend money to the government. What you want, of course, is an inflation-adjusted, positive return.

What is interesting is that coming into this year, there were a lot of tailwinds for the gilt market. The UK’s fiscal deficit was beginning to fall from a sticky 5.2% to where we are today, which is around 4.3% of GDP, according to an Office of Budget Responsibility estimate.

That was positive because it meant that the volume of gilts the government needed to sell to fund its deficit had fallen to £250 billion from around £300 billion.

On top of that, the way gilts are funded has shifted dramatically from the long end to shorter-maturity gilts. So that means the amount of interest rate risk being supplied to the market is coming down. This stands in contrast to much of the euro area.

Do investors recognize this shift is underway?

It’s not being reflected in market pricing for a number of reasons. There is less demand from UK pension funds for long-duration bonds. And even though the market is in a good place in terms of the deficit, investors don’t have conviction that the fiscal rules are going to hold. Again, this is really about political uncertainty, and the last two weeks have brought that into the spotlight. Now we have this situation where 30-year gilts are within touching distance of 6%.

Could you elaborate on the issue of fiscal rules? And how does that influence what’s happening in the gilt market?

We have a prime minister and a chancellor who have tied themselves to their fiscal rules and the market has used that as an anchor. Amid the political uncertainty, the market is watching closely for any signs of a change in approach, in particular any move towards a more expansionary fiscal policy that would require more borrowing or higher taxes. If you lean more on the borrowing side, that can be a problem for the gilt market, and that is effectively where we are today.

How does the Bank of England respond to this development?

The Bank of England tends not to make policy moves based on politics alone. And in general, it is a reluctant hiker. While core inflation is uncomfortably high, wage inflation is coming back toward levels consistent with the inflation target, so it is a much better environment than the last time we had an energy price shock in 2022.

At the same time, I think there is an understanding that unless the Strait of Hormuz opens, there is going to be further energy supply shortages going into the winter. The Bank of England will be thinking about this as well. There may be a limited hiking cycle to take some heat out of the economy, effectively insurance hikes against the pass-through of energy prices. The possibility of two rate hikes that are currently priced into the market this year makes sense.

Is the gilt selloff affecting the pound?

It has been a little surprising how well sterling has been trading. I don’t think we are looking at capital flight. With clear pressure on the bond market and the Bank of England not hiking on the back of the politics alone, I thought you would have seen more weakness in the currency.

Does this episode feel like a replay of the spike in interest rates in 2022?

At that time, pension funds were the main holders of long-dated gilts, often funded through the repo market, and they were forced sellers as gilt yields spiked and collateral values fell. That’s not the world we are in now. There are pockets of demand that are quite positive. Bank treasuries are still buying front-end gilts, usually on asset swaps.

They aren’t willing to take the interest rate risk, but they are willing to take the credit risk of the government. On the long end, UK insurers are the same. Either way, we think neither group will be under any pressure to sell here.

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