(May 14): Bond-market volatility sparked by the UK’s latest political crisis is serving up a reminder that the government can’t take foreign demand for granted.
About a third of the government’s gilts is in the hands of overseas investors who can easily shift money elsewhere during a crisis and are spoiled for choice in a world awash with debt. Officials have warned about the growing role played by hedge funds that may be forced to unwind leveraged trades if the bond market moves the wrong way.
The dynamic famously turned Liz Truss into the nation’s shortest-serving prime minister in 2022, when yields surged as foreign investors joined locals in a rush for the exits, dumping a record amount of bonds on concerns about her fiscal plans. A smaller selloff briefly rattled the market last summer on speculation that Prime Minister Keir Starmer would dump his Chancellor of the Exchequer and potentially do away with her fiscal rules.
Now, Starmer is headed into a divisive battle to keep his job after the populist party Reform UK dealt his Labour Party a significant defeat in last week’s local elections. Starmer’s former deputy, Angela Rayner, indicated on Thursday she was preparing for a leadership bid, while Wes Streeting, who is expected to mount his own challenge, resigned from his position of health secretary.
The jump in yields has also been fuelled by concern about the inflationary impact of the Iran war, which has driven up borrowing costs around the globe. But even with 30-year yields around the highest since the late 1990s, the risk is that foreign investors are deterred by the persistent uncertainty and volatility that’s become synonymous with gilts.
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“People are trying to stay out of it and see how this plays out,” said Antonina Tarassiouk, director of international economic analysis at Reams Asset Management, a US firm. “If rates have become attractive globally speaking, why would you go to somewhere where there’s significantly more risk right now?”
Gilts edged higher on Thursday, leaving 10-year yields five basis points lower at 5.02%. The gains mirrored a move across global government bond markets, which closely track fluctuations in oil prices.
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Some of the volatility stems from the scale of the UK’s national debt, which has swelled sharply since the pandemic and is now at its highest, relative to the size of the economy, since the 1960s. At the same time, industry changes have chipped away at domestic pension funds’ role in the market. Other less patient investors have filled the gap.
Edmond de Rothschild, the Swiss private bank and asset manager, is advising clients to stay away from long-maturity gilts, citing the political uncertainty against a challenging economic backdrop. It said the UK bond market is “significantly less liquid” than its German and French peers.
“Political instability could trigger gilt-selling in an already illiquid market,” Nicolas Bickel, the group’s head of investment private banking, wrote to clients. “In addition, foreign investors must factor in the extra risk of a potential depreciation of the pound.”
‘Fickle and flighty’
The head of the UK’s fiscal watchdog, the Office for Budget Responsibility, last year warned about the government bond market’s dependence on “fickle and flighty” investors. In a speech on Wednesday, Bank of England rate-setter Catherine Mann voiced similar concerns, highlighting the risk that a shock could upend the market if foreign or highly leveraged investors sold in unison.
UK Chancellor Rachel Reeves has warned that a leadership contest would plunge the UK into chaos. With borrowing costs spiking, Starmer’s allies argue that the political turmoil is distracting the government at a time when the UK is already struggling with slow growth, weak employment and rising inflation as a result of war in Iran.
Daniel Siluk, head of global short duration and liquidity and portfolio manager at Janus Henderson, says he’s responded to the volatility by closing direct UK duration positions.
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“Given the elevated and idiosyncratic risk around UK gilts, our strategy has been to limit exposure and seek duration in more stable markets until confidence in UK policy stability improves,” he said.
UK politics aren’t the only force weighing on the nation’s bond market. Yields have jumped sharply around the world since the US war against Iran sent oil prices spiraling, increasing speculation that central banks will need to raise interest rates to contain inflation. But the levels in the UK stand out against other developed-world peers, with the government’s 30-year rates more than two percentage points higher than Germany’s and higher than in Italy, Spain or Greece.
That means not everyone is bearish. For Hideo Shimomura, a senior portfolio manager at Tokyo-based Fivestar Asset Management Co, the UK can’t sustain a loss of fiscal discipline and its bond market selloff may be overdone, especially relative to peers.
“There’s a chance global yields continue to rise, so I wouldn’t expect gilt yields to completely turn and drop significantly,” he said. “But on a relative basis, there’s a case to be made for the UK.”
Some sort of political resolution that reduces price swings may help restore the appeal of UK debt.
“The longer this volatility goes on, the less appealing” gilts are to foreign buyers, said Al Cattermole, fixed income portfolio manager at Mirabaud Asset Management. “The yield on gilts will have to be high enough to attract international investors.”
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