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: %)
Source: 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)
Source: 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.
The comments, opinions, and estimates contained herein are based on and/or derived from publicly available information from sources that PGIM Fixed Income believes to be reliable. We do not guarantee the accuracy of such sources or information. This outlook, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. Past performance is not a guarantee or a reliable indicator of future results.
Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of January 2025.
For Professional Investors only. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. All investments involve risk, including the possible loss of capital.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. PGIM Fixed Income as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Investors seeking information regarding their particular investment needs should contact their own financial professional.
These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.
Any forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fee. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government agency or private guarantor, there is no assurance that the guarantor will meet its obligations. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Diversification does not ensure against loss.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR.PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited including those available under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In Switzerland, information is issued by PGIM Limited, London, through its Representative Office in Zurich with registered office: Kappelergasse 14, CH-8001 Zurich, Switzerland. PGIM Limited, London, Representative Office in Zurich is authorised and regulated by the Swiss Financial Market Supervisory Authority FINMA and these materials are issued to persons who are professional or institutional clients within the meaning of Art.4 para 3 and 4 FinSA in Switzerland. In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a regulated entity with the Monetary Authority of Singapore under a Capital Markets Services License to conduct fund management and an exempt financial adviser. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 -Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2024 PFI and its related entities.
2025-0891
Collapse Section