Macroeconomics
TheVulnerability—andPotentialValueCreation—inUKAssets
5 mins
The recent spike in Gilt yields confirmed the UK’s inclusion in a small, but potentially growing, set of developed market countries demonstrating increased sensitivity to fiscal concerns. After the “mini-budget” jump in Gilt yields in late 2022 and two fiscally-related selloffs in French OAT yields last year, UK budget concerns again contributed to the latest volatility.
Yet, this recent action may have a reaction that leads to a credible fiscal tightening and keeps the prospect for Bank of England rate cuts broadly intact. At the margin, the mix of fiscal constraint and the easing of monetary policy could be growth positive for the UK, while potentially reducing the country’s vulnerabilities and increasing demand for UK assets. The following explores when that point may materialise in the context of the recent market stress.
Although UK economic fundamentals are rather lacklustre, they are not the worst of its peers. Indeed, the UK economy is not only expected to marginally improve in 2025, but it is also expected to outperform core euro area economies, such as Germany and France. Therefore, rather than a shift in UK fundamentals, the relative strength of the U.S. economy and the prospects for shallower Fed rate cuts drove the recent market volatility. Figure 1 shows the recent stress on UK assets in the context of the 2022 selloff.
Figure 1
Recent stress on UK assets accumulated gradually, rather than abruptly as in 2022 (left: bps; right: %)
Bloomberg and PGIM Fixed Income
So, what made the UK more exposed than its peers to the recent global duration selloff? First, some worrying signs of stagflationary risks from high-frequency soft indicators (e.g., the UK Decision Maker Panel Survey) raised additional investor concerns. Second, the UK will likely remain more vulnerable to global shifts in investor sentiment due to the following:
- The October 2024 Labour budget fell short of demonstrating fiscal discipline with a growth-friendly focus;
- The damaged credibility of UK institutions after Brexit and its proacted negotiations, as well as the Truss-Kwarteng budget from October 2022. Once lost, trust takes time to rebuild;
- The real-time implications that Bank of England balance sheet losses have on UK fiscal conditions. The BoE’s lack of financial independence has triggered a negative market spiral where higher interest rates generate more central bank balance sheet losses that further impinge on fiscal space. The radical transparency has been counterproductive during times of fiscal stress;
- Following Russia’s invasion of Ukraine, UK energy prices peaked 60% above year-end 2021 levels vs. 40% in Europe. As a result, the dent in policy credibility and cost of living was more detrimental in the UK than in the euro area; and,
- Unlike its European peers, the UK is also more exposed to U.S.-driven global financial conditions and inflation spillovers via its exchange rate. Moreover, the UK has run a current account deficit since the early 1990s, making the exchange rate vulnerable to changes in investor sentiment. Further, it lacks a second line of defence in the form of risk sharing that benefits larger economies, such as the U.S. and euro area, during times of stress.
Furthermore, three technical aspects also contribute to the vulnerability in UK assets, including:
- The composition of UK government debt consists of shorter maturities and more floating-rate coupons (including index linked), making it more susceptible to shifts in market sentiment (Figure 2);
- The interest payments on UK government debt comprise a relatively high percentage of GDP and government revenues. Markets often look to these metrics on emerging market economies in order to assess “ability to pay;” and,
- The heavy issuance of UK government debt to start 2025 with little market appetite to engage in auctions. Issuance is expected to remain high throughout the first quarter of 2025.
Figure 2
The composition of UK debt may make it more volatile during periods of stress (% of total)
Macrobond
Despite these vulnerabilities, the latest UK episode is not a rerun of the abrupt yield surge during the Truss fiasco of October 2022 (refer to Figure 1).
In that sense, recent market moves look more like a structurally-driven repricing of UK risk. As such, the current bout of stress could continue subsiding. Still, given the factors above, the UK may remain vulnerable to changes in investor sentiment, especially amidst shifting central bank expectations, geopolitical risks, and uncertainty related to the Trump administration.
If higher Gilt rates return and persist, the Chancellor could adjust her fiscal plans. The wafer-thin headroom afforded by the October budget will have evaporated and the “non-negotiable” fiscal rules could prompt more spending cuts than tax increases, at least in the first half of this year. Under this scenario, the BoE may proceed with its balance sheet runoff plans, but could temporarily pause sales if market moves become disorderly.
Seeking Catalysts
Ultimately, for investors to be more confident about UK assets they would need to see more stability in the global and domestic factors that drove the selloff. On the global front, U.S. yields have declined on recent data that indicate inflation may converge towards target as the U.S. economy gradually cools.
On the domestic front, a firmer commitment to fiscal prudence could hurt short-term growth, but it would allow the BoE to cut rates more decisively. This gives us more confidence about the front end of the Gilts curve. The long end also offers value, but investors will find it riskier amidst the global reassessment of term premia.
Other UK risky assets, such as the currency and corporate bonds, would also benefit from reassurance of fiscal responsibility and further stability in U.S. yields. In fact, UK corporate bonds didn’t suffer much in the recent Gilts selloff. Technical factors, such as limited issuance, helps in the context where investors are focused on all-in yields.
The bar for GBP outperformance might be higher. Positioning has been long GBP, and the unwind of those longs hurt the currency. In addition, if fiscal prudence leads to more aggressive BoE cuts, GBP may lose further support, most notably relative to the USD. That said, the U.S. is facing its own deteriorating fiscal conditions and an increase in concerned observers.
Considering the issues above, if the eventual result in the UK is more credible fiscal and a pro-growth agenda, GBP assets could outperform in 2025. But that point has yet to appear.
More Insights
All the Credit
Credit Markets in Transition: Liability Driven Investing, A Multi-Sector Approach Apr 3, 2025
