Bond Sell-Off: Implications for the US and UK Markets

Global government bonds have come under pressure recently due to concerns about fiscal deficits and fewer rate cuts than expected both in the US and the UK. We look at the implications of this sell-off, focusing on the US and UK markets.

UK and US yields have risen by over 100 bp since the Federal Reserve began to cut interest rates in mid-September. The victory of Donald Trump in the US presidential elections in November and a fiscally expansive UK budget in October led both inflation and sovereign bond issuance expectations to rise materially. This was compounded by rising commodity prices and better data on the US economy interacting with a market that had been expecting aggressive rate cuts (Figure 1).

A key difference during the selloff however lies in growth expectations for 2025 being revised up 0.4% for the US from mid-September levels, while they have remained static for the UK. In effect, yields have been rising for the “wrong” reasons in the UK, reflecting higher inflation and issuance expectations but anemic growth. In this environment, the correlation between relative yield moves and FX performance can break down, and this began to take place in December with UK yields rising versus peers, but sterling weakening.

Valuations and Opportunities in the US

The recent selloff has increased the attractiveness of sovereign bonds relative to long-term trend growth and inflation dynamics, with relatively high levels of term premium currently being priced. This is now combined with little expectation of further movement in short-term rates. Long-term investors are likely to be rewarded for taking duration risk at these levels, not only in terms of yield/carry, but also in terms of likely positive attributes of bonds when broader risk markets wobble and/or recession risk comes back to the fore. Most yield in fixed income is coming from sovereigns, as credit spreads are extremely tight. This should mean tilting allocations toward government rather than credit markets.

Upside risks to rates from supply are likely to remain, as high deficits along with uncertainty around policies continue to weigh on the market. However, we remain long US duration in accounts that can underwrite this risk, focused on short and intermediate maturities expecting further curve steepening. We have shifted some of the nominal exposure to Treasury into Treasury Inflation-Protected Securities (real duration) as long-term real yields move towards 2.5%. We also remain conservative overall on risk assets, favoring structured credit markets over corporate credit markets.

As far as the US dollar is concerned, it has moved in lockstep with the rise in rates and is likely to continue to be so unless there is a significant risk event. This has important knock-on effects for the rest of the world as the US dollar remains the preeminent reserve currency for the world.

Valuations and Opportunities in the UK

In the UK, pension schemes are in a much better place compared to 2022, with much lower levels of leverage, higher levels of collateral, and better processes in place for meeting collateral calls. Higher government bond yields will lead to a lower present value for the future liabilities of pension schemes. This will see better funding levels for pension schemes that are not fully hedged against moves in government bond yields. This may present opportunities for pension schemes to further increase hedge ratios, though this will need to be evaluated against their collateral levels and overall asset allocation.

In the short term, the weak growth/sticky inflation environment in the UK makes for a challenging backdrop for government bonds, as monetary policy cannot be lowered quicky and fiscal deficits may be difficult to improve. This can lead to concerns about high levels of government bond supply, and the creditworthiness of the UK government, at a time when the core bank rate remains relatively high. While growth has been weak, it needs to weaken further to offset above-target inflation expectations, and for Gilt yields to rally meaningfully versus peers.

Is This Sell-off a Longer-Term Challenge?

As government bond supply is likely to remain elevated globally over the coming years, the market will need to find a level in yields which encourages fresh buyers to the government bond market. Term premium – a measure of how much extra yield is required to entice government bond buyers to shift into higher maturity bonds – has been on a rising path, and given the supply backdrop, it may have to rise further to make valuations attractive.

However, this can also provide an opportunity as investors become better compensated for this risk, especially as valuations in risky asset markets are high. Any further substantial cheapening in government bonds may have an adverse effect on corporate bond and equity markets leading to a more negative correlation between government bonds and risk assets going forward.