UK: Ghosts from the Past?

Risk assets came under pressure last week as rising global bond yields continued to raise questions about the economic outlook.

Another month of solid job growth in the United States helped to push 10-year U.S. Treasury yields to their highest close since 2023 and the dollar to its strongest since 2022. Behind those moves is an increasingly hawkish outlook for the Federal Reserve, which is now priced to deliver just one 25 basis point (bps) cut in 2025.

The good news for U.S. investors is that yields are being pushed higher for “good” reasons in the form of a stronger economy. However, movements in the UK markets last week served as a reminder that higher borrowing costs in the absence of economic growth can have more serious implications.

Today, we dig into the recent volatility across UK markets, explore the reasons behind it, and what might come next.

UK: Ghosts of the Past?

Over the last week, 10-year UK Gilt yields hit their highest level since 2008 and 30-year yields reached their highest since 1998. At the same time, the pound dropped to its weakest level against the dollar in over a year. Those types of moves (yields higher, currency weaker) are not typically what you would expect to see, and appear to reflect the challenging mix of sticky inflation, low growth, and fiscal sustainability worries that have been lingering in the UK for some time.

Regardless of the specific drivers of the moves, rising borrowing costs paired with currency weakness tends to signal a degree of fiscal risk being priced in. We saw similar dynamics playing out in Europe towards the end of last year, and we expect that debt sustainability concerns will continue to play a role in global markets in 2025.

The UK situation specifically is looking increasingly precarious. The government left themselves with very little room for manoeuvre at the Autumn Budget, and the £10bn buffer that they did leave themselves (to meet the modified “fiscal rules”) has been eroded by the rise in borrowing costs since.

When you consider that business activity and hiring intentions appear to have slowed down in response to higher taxes too, it certainly doesn’t feel like the government will be getting bailed out by growth any time soon. That rings even more true when you consider that the Bank of England is likely to be sidelined for much of 2025 given persistent inflation concerns. That probably means that spending cuts can be expected if these recent moves in Gilt yields hold.

As UK policymakers contend with policy credibility concerns, these moves will also likely act as another warning sign for other governments seeking to increase borrowing for spending purposes. With elections less than two months away in Germany, the potential for the country’s so-called “debt brake” to be relaxed risks similar consequences. And as France contends with ongoing budget discussions, striking the right balance between spending and fiscal credibility has rarely been as important. That is before we even speak about the United States, where worries about wide budget deficits appear to be the known unknown for markets heading into 2025.

What to do?

Moves like these are always challenging to fade when momentum appears to only be trending in one direction. However, we think that recent volatility could bring opportunities for individuals and investors with varying currency needs.

The 10% weakening in the pound versus the dollar since the highs just three months ago is notable. That has actually coincided with higher carry (i.e. interest rates) relative to other regions, but the quality of that carry has been deteriorating as growth data has come in on the softer side. That could keep the currency under some pressure relative to the dollar, but we do think that the size of recent moves is difficult to ignore and may provide a chance to start accumulating pounds for those with needs in the currency.

The surge in UK Gilt yields has also now taken the yield premium relative to U.S. Treasuries to one of its widest levels since the financial crisis. UK taxpayers in particular might consider using the recent back-up in yields to top up their Gilt holdings, given the exemption from capital gains. That means that, for example, a UK government bond maturing in 2035 that was issued at a near-zero coupon may now offer a gross-equivalent yield in excess of 8%! The opportunity to obtain these more attractive after-tax yields (over 4.5%) is only a recent phenomenon created from the low coupon issuance over the last decade – coinciding with rising yields.

More broadly, global investors should take this as an opportunity to reconsider their asset allocation. It may be prudent to consider altering fixed income allocations to focus on shorter durations (5 years and in) to reduce overall portfolio volatility – particularly with an incoming Republican party potentially raising deficit concerns and inflation uncertainty. Beyond that, last week was a clear example that stocks and bonds might not exhibit the same negative correlation that they once did. Consider less correlated assets like gold and infrastructure to boost portfolio resilience ahead of 2025.

As always, please reach out to your J.P. Morgan team for any further questions.