Gilt yields – effectively the level of interest that the UK government pays on its debt – rose to their highest level in almost 30 years on 5 May, amid the fallout of the conflict in Iran.

Yields on 30-year gilts reached 5.79% on 5 May and closed the day at 5.74%, marking the highest level for long-dated UK government bonds since the first quarter of 1998.

Shorter-dated gilts yields have also spiked. Yields on 10-year gilts rose to 5.11% on 5 May and closed at 5.06%. Prior to March this year – when 10-year gilt yields briefly reached 5.12% on 23 March – the last time that 10-year gilt yields rose above 5% was in July 2008, early on in the Global Financial Crisis, when they reached a peak of 5.26%.

“The UK is not alone in dealing with disruption from the Middle East but is particularly vulnerable to higher energy costs,” said Anna Macdonald, investment strategy director at wealth manager Hargreaves Lansdown. “The UK is a net energy importer and already faces some of the highest electricity and gas costs in developed markets.”

Local elections which will take place on 7 May also contributed towards the gilt yield spike.

Besides impacting the cost of government borrowing, gilt yields have an impact on your personal finances via mortgage and annuity rates. They can also be a safe investment for your portfolio, on the basis that the UK government is unlikely to default on its debt.

What are gilt yields?

Gilts are bonds issued by the UK government, and as such they are the mechanism through which the government borrows money.

Like all bonds, gilts pay regular income to their owner (who is effectively the person who has lent the government money). The amount of income they pay is fixed, but the price of a gilt can (and does) change depending on how the market perceives the government as a borrower at any given time. If the market sees the government as an attractive borrower, the price will rise, and vice versa.

The yield on any bond (including a gilt) is the amount of income it pays as a percentage of the price of the bond. So a gilt yield is the amount that a gilt pays as a percentage of its price.

When gilt prices fall, their yields rise, and vice versa. So when the market perceives the UK government as a more risky borrower, gilt prices fall, pushing yields up.

The perceived vulnerability of the UK economy to the disruption caused by the conflict in the Middle East has made gilt yields rise.

“Investors are responding by demanding a higher premium to hold UK debt,” said Lale Akoner, global market analyst at investing platform eToro. “If uncertainty persists, upward pressure on yields is likely to remain, with broader implications for borrowing costs and financial conditions across the economy.”

What do rising gilt yields mean for your money?

Gilt yields impact various aspects of the economy and your personal finances.

Higher gilt yields typically mean that mortgage rates will increase, because mortgage rates are typically linked to the yields available in the bond market.

On the other hand, higher gilt yields often mean that annuity rates increase. This could benefit people looking to buy an annuity with some of their pension savings, for a guaranteed income in retirement.

Rising gilt yields also make it more expensive for the UK government to borrow money. This could have knock-on effects in areas like reduced public spending or higher taxes over the longer term.

Should you invest in gilts given higher yields?

In general, gilts – like most forms of government bonds – are considered a very safe investment. The UK government has never defaulted on its debt.

Some argue that it never would – instead, the government might take steps that devalued the pound to the extent that inflation outweighed the value of the interest payments, which remain fixed in nominal terms.

Higher gilt yields mean that gilts are currently relatively cheap. If you are considering adding gilts to your portfolio, now isn’t a bad time – but remember that gilts are cheap for a reason. Markets are pricing in a relatively high likelihood that the UK government’s ability to repay its debt (without hurting its value in real terms) will be constrained for the foreseeable future.

If you do want to buy gilts, some investment platforms will allow you to buy them directly, or you could use an exchange-traded fund (ETF) like Vanguard’s UK Gilt UCITS ETF (LON:VGOV) which tracks an index of gilts with maturities (i.e. lifespans) of one year or more.

Gilt yields – effectively the level of interest the UK government pays on its debt – fell to its lowest level since 2024.

Yields on 10-year gilts fell to 4.37% on 12 January, before edging up to around 4.39% the following day. The figure was above 4.4% for the whole of 2025; this time last year, they were approximately 4.9%.

“So far, 2026 has seen gilt yields fall,” said Hal Cook, senior investment analyst at Hargreaves Lansdown. “Most of the move was last week, but they fell a little further on Monday following relative UK strength compared to the US where Fed Chair Jerome Powell is – yet again – under attack from the White House.”

Last year, a succession of gilt yield surges piled pressure on UK chancellor Rachel Reeves in the build-up to her Autumn Budget.

But in the aftermath of the Budget, gilt yields fell as bond markets were reassured that Reeves had given herself extra fiscal headroom.

A gilt is a bond the UK government issues to borrow money. As with all bonds, gilt yields move in the opposite direction to their price.

In effect, when gilt yields fall, UK government bonds have increased in price – making it less expensive for the government to borrow.

How is the government bringing gilt yields down?

Bond investors like a credible borrower. Gilts are a mechanism through which the UK government borrows money. Just as any bank or building society would if you approached them for a mortgage, bond investors assess the creditworthiness of the UK government before they lend it money.

The UK hasn’t been viewed particularly well on that front (considering its position as one of the world’s largest economies) for some time, but the extra fiscal headroom carved out in the Budget gave Reeves a smidge of credibility.

But a persistent issue is oversupply. The UK government has £2.9 trillion worth of debt and pays £110 billion per year just on servicing the interest. This makes new gilts less attractive to potential buyers – there is already a lot of UK government debt in the market, and the amount it spends servicing that debt makes it a less credible borrower.

Compared to other developed economies, much of this debt is in long-dated bonds.

Bloomberg reported on 12 January that the government is taking active steps to reduce this long-dated debt. It is starting to issue more UK Treasury bills (T-bills).

What is a T-bill?

T-bills are short-dated government bonds. They mature after a minimum of one day and a maximum of 364, though according to Laith Khalaf, head of investment analysis at AJ Bell, most have a maturity of one month, three months or six months.

“Like Government bonds, or gilts, they are loans to the government and therefore have a very high level of safety, as you are guaranteed your money back unless the UK government defaults on its debts, which is extremely unlikely,” says Khalaf.

Unlike gilts, though, T-bills don’t pay any income. They are sold at a discount to their face value. When they mature, the government buys them back at their face value – meaning the investor pockets the difference between the two prices.

Earlier in January, the Debt Management Office (DMO) – the agency that issues gilts and other forms of government debt – said it was exploring the possibility of issuing more T-bills to reduce the amount of long-dated government debt.

“The increased flexibility that comes with issuing shorter-dated paper, particularly when there are concerns around longer-term debt affordability, are a plus,” said Cook. “It’s also positively viewed by a market that has fewer buyers of longer-dated gilts today than it did a few years ago.”

The government hasn’t yet increased its T-bill issuance, but bond markets appear to have reacted positively to the government’s intention of reducing the proportion of long-term debt on its books.

“It's for this reason that longer-dated gilt yields have fallen further than shorter-dated ones, with the 20-year yield dropping around 17bps since the start of last week,” said Cook.

The Scottish government has announced plans to sell up to £1.5 billion of its own debt over the next five years, the first time the country has issued its own bonds in more than three centuries. The “kilts”, as they will inevitably be known in a play on the British “gilts”, will help finance the devolved administration. The plans took a step forward last week when two of the major agencies, Moody’s and S&P, gave the planned issue an investment-grade rating. The Scottish National Party plans to press ahead, in part to give it more money to play with, but also, perhaps more importantly, to demonstrate that Scotland can flourish on its own and have credibility in the markets.

The trouble is, it is not likely to work out that way. The ratings agencies were quite clear that they were grading Scotland on the basis that it was still part of the United Kingdom, and the debt backed by the Bank of England and the Treasury in London. If Scotland were an independent country it would surely be a very different story.

To start with, Scotland runs a huge budget deficit. For 2024-2025 it rose from £21 billion to £26 billion. That is 11% of GDP, compared with 5.1% for the UK as a whole. If you took out oil, which might not all go to Scotland in a separation agreement with the rest of the UK, it would rise to a terrifying 14%. The rise was largely on account of lower revenues from North Sea oil and gas, but the SNP is fiercely opposed to the oil industry, and wants to close it down as quickly as possible, so the deficit would be a lot worse if the country became independent. Its deficit would rank as one of the highest in the developed world. It is behind Timor-Leste, at 48% of GDP, and Ukraine at 18%, if above Egypt and Zimbabwe. It is hard to believe that borrowing on that scale would be sustainable for very long.

Next, Scotland has a political class that is addicted to spending. Ever since the devolved government was created at the start of the century the one thing it has proved very good at is giving away free stuff. Higher education does not have to be paid for, and neither do prescriptions, or bus travel if you are under 22 or over 60. It makes politicians sound generous. Some of that is paid for with higher income-tax rates in Scotland than in the rest of the country, but most of it comes from subsidies from London. Public spending is already more than £2,000 per person higher in Scotland than in the rest of the UK, but the budget deficit is still huge. It is hard to see any government in Edinburgh changing that.

It's hard to think of anything worse than Scotland's proposed 'kilts'

Finally, Scotland may break away from the UK at some stage, and, if it does so, it may have to issue its own currency. The SNP has always maintained that it can carry on using the pound after independence, if it ever happens, and the Bank of England will remain the ultimate guarantor of its debts. But the government in Westminster has never agreed to it and neither has the Bank. It is hard to see why they ever would. Anyone holding a “kilt” has to reckon with the possibility that Scotland may have to issue its own currency at some stage and that it will sharply devalue against the pound. Measured in sterling, or indeed dollars or euros, they will face huge losses on their holdings.

In reality, it is hard to think of a worse investment. A market in “kilts” will make that painfully clear almost as soon as it is launched. It might start out trading at the same price as UK-issued gilts, but it will very quickly start to deviate from that. If a second referendum on independence is mooted, prices will plunge if there are polls showing a “yes” vote, which paradoxically, will make that outcome far less likely.

If there is a prospect of a vote being held, prices will start to sink as investors weigh the possibility that it might be a Treasury in Edinburgh rather than London that has to pay them back. Scottish politicians pushing for “kilts” might imagine it will strengthen the case for independence and bolster their financial credibility. More likely is that it will backfire spectacularly, making it clear that an independent Scotland would struggle to pay its bills.

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Bond and equity investors are fundamentally in opposition. A bondholder cares only about receiving their interest and capital; anything that puts that in danger is bad. The ideal borrower might be one that takes your cash, parks it in ultra-safe assets to protect the principal and makes paying the coupons the only priority for its cash flow. There is no upside if the borrower takes risks. In fact, there is not even much value in long-term survival: the borrower can fail due to a lack of investment and the bondholder is still happy if they have been repaid in full.

On the other hand, equity – “the fine sliver of hope between assets and liabilities”, as Russell Napier calls it – hopes to profit from growth in earnings or assets. Shareholders want the company to take some kind of risk because they benefit if that risk pays off. If that might increase the chance that loans aren’t repaid, so be it.

This is well understood by markets. Nobody expects bondholders and shareholders to speak in each others’ interests. Yet when it comes to the public finances, that gets completely lost.

All about the bonds

Today, we hear endless talk about why the chancellor needs to cut spending, raise taxes or both. Look at this through the bond-equity framework, and we can see that this is framed in bondholders’ terms: it’s all about making them feel more secure. The discussion rarely touches on whether borrowing is rising because of current expenditure or long-term investment.

Bond investors could make a very valuable intervention by signalling that borrowing to invest in the infrastructure that Britain needs (with a well-costed plan) would be seen very differently from borrowing to fund profligate current expenditure. Yet most talking points simply boil down to “large deficit = bad”.

This reasoning gets stretched into some bizarre pretzel logic. Raising taxes will slow growth since disposable income will be reduced, we are told approvingly. That may curb inflation and allow interest rates to be lowered, which is good for bonds. Yet the idea that anybody else would want weaker growth in an economy that is clearly not overheating is frankly unhinged.

Equity holders in this scenario are everybody who benefits from a stronger economy and more investment. And this is where long-term consequences of the current mindset look so worrying. Consider the visible deterioration in physical and social infrastructure in Britain. Failure to fix this because the government is cowed by the self-important bond vigilantes will open the door further to populist parties.

At present, UK 10-year gilts yield 4.4%. This is not high by past standards: it only feels high because of 15 years of ultra-low rate policy. True, it is high enough that rising interest costs puts even more strain on public finances, which makes the challenge even greater. But what compensation does it offer for, say, the inflationary risk of a future government in five years’ time with a populist mandate to spend and willingness to be radical? Very little.

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How has monetary policy shifted?

Over the past 25 years, monetary policy in advanced economies has undergone an astonishing, unprecedented transformation – dramatically changing in both scope and scale, and blurring the boundaries with fiscal policy. When MoneyWeek published its first edition, there was a broad consensus on inflation targeting, operational independence for central banks and faith in the ability of short-term interest rates to stabilise output and prices. But those turbulent 25 years have seen a radical shift. From the “Greenspan put” to quantitative easing (QE – printing money to buy government debt), monetary policy has evolved in ways that are highly controversial and politicised. Central banks today have vastly higher balance sheets, in some cases manage entire yield curves (that is, use policy to influence rates across different maturities of government bonds, not just short-term rates) and openly coordinate with fiscal authorities in emergencies.

Why is this controversial?

Because, critics argue, the gigantic balance sheets held by unelected central banks as the result of QE, and their “unconventional” monetary policies, have inflated asset-price bubbles, fostered inequality, led to misallocation of capital, and masked unsustainable public finances. Long-term, the chief purpose of monetary policy is to inspire confidence in the value of money by encouraging price stability. In the short or medium term, the aim of policy is to keep the real economy stable – supporting sustainable growth and employment – and to contain risks. Since the turn of the century, however, independent central banks have radically over-interpreted that brief by consistently coming to the rescue of equities and debt markets in ways that have distorted business cycles and deferred pain. Emergency measures have become the norm, and central banks have ballooned.

How have central banks expanded?

For almost the whole of the 20th century, the central-bank assets of advanced economies, as a proportion of economic output, remained remarkably constant, at around 10%-13% of GDP. But in the aftermath of the great financial crisis of 2007-2008 – as governments everywhere turned to QE – that proportion surged, rising above 20% in 2009-2010. And rather than falling back to normal levels as the crisis stabilised, that proportion then doubled once more during the 2010s to 40% – before spiking up to 70% in the aftermath of Covid. Even by 2024, it was still 50%. That’s a revolutionary change in the size of central banks’ financial assets within a couple of decades. Historically, balance sheets merely reflected operations. Now, they are strategic levers shaping long-term yields and risk premiums – a fundamental conceptual shift.

Was QE justified?

Yes, in the immediate aftermath of the financial crisis, decisive action by central banks was vital in stabilising economies and preventing deflation, says Andy Haldane in the Financial Times. By contrast, “later-stage QE, including purchases made in response to Covid, is harder to justify. With fiscal policy highly expansionary, QE’s primary purpose was to placate fretful bond markets rather than boost inflation” – a worrying step towards “fiscal dominance”. Vincent Reinhart, the chief economist at BNY Investments, co-authored two research papers on QE with Ben Bernanke, chairman of the Federal Reserve from 2006-2014, who instituted QE following the financial crisis. “We did not include a section on how to get out of the policy, or the risks stemming from it,” he now says. “That was a mistake – it was a lot stickier than I thought going in and has opened up a range of complications and potential political influences on monetary policy.”

So it’s been hard to get out of?

Indeed. The current era of gigantic public debt has blurred the lines between monetary and fiscal policy, since rate rises (or quantitative tightening) put up debt-servicing costs and infuriate the likes of Donald Trump. In the UK, quantitative tightening triggers indemnities that require the Treasury – ultimately, the taxpayer – to cover central-bank losses. In addition, by pushing up gilt yields, it makes it more expensive to the Treasury to borrow and service its debts. That makes monetary policy more politically charged than ever, and the target of populists who regard central bankers as sources of unelected and illegitimate technocratic power.

What are the limits on monetary policy?

Conventional monetary policy is a famously blunt tool. It has become blunter in recent decades. Financial globalisation and the absorption of China into the global economy, technological change and demographic ageing have lowered real rates. There’s been a relative decline in floating rate debt, meaning rate changes do not necessarily feed through into the wider economy. And rate-sensitive capital-intensive sectors, such as manufacturing and construction, have diminished in favour of services, which are more labour-intensive and less responsive to interest rates, says Marco Casiraghi, director at Evercore ISI. All of this makes monetary policy harder to frame and execute with confidence.

A tough gig, then?

The Bank for International Settlements says that everyone, from governments to central banks to investors and consumers, needs to become more realistic about monetary policy. The idea that it alone can underpin growth is an “illusion”. And the trade-offs that monetary policy involves will “become unmanageable” without “more holistic and coherent policy frameworks in which other policies – prudential, fiscal or structural – play their part”. Central bankers may be even more powerful than 25 years ago. But in an ever more complex and turbulent century, even they recognise that they are not magicians.

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The run up to the Budget in November has already been dominated by headlines about a “meltdown” in the bond market and a yawning “£50 billion” black hole that will have to be filled by more tax increases. Some have even speculated that the UK is heading for another IMF bailout. Mercifully, the prospects may not be quite as dire as these reports suggest. But the recent increases in the cost of government borrowing are consistent with an emerging fiscal crisis. The chancellor is increasingly boxed in by her own fiscal rules – and there is no painless way out.

The problems are most apparent in the yields on 30-year UK government bonds, known as “gilts”, which have jumped to their highest level since 1998. This partly reflects a global shift upwards as investors become more jittery about increases in public debt worldwide. Similar headlines are being written in many other countries, notably France and Japan.

Nonetheless, the UK now consistently has the highest bond yields in the G7 group of advanced economies. The cost of new government borrowing for 10 years is currently around 4.6% in Britain, compared with 4.0% in the US, around 3.5% in France and Italy, 3.2% in Canada, 2.7% in Germany, and just 1.6% in Japan. This is all the more remarkable because UK public debt is not particularly high by international standards. In fact, the ratio of debt to national income in the UK, at around 100%, is lower than in Italy, at 135%, and much lower than in Japan, at 240%. Even Greece, with debt still over 150% of GDP, can borrow at 3.3%.

Why the UK seems stuck in a doom loop

Why has the UK become such an outlier? There are three main reasons.

First, many international investors are losing confidence in the Labour government’s willingness to take tough decisions to bring borrowing down, especially after the recent failures to curb welfare spending.

The prospect of more tax rises is simply reinforcing fears that the UK is stuck in a “doom loop” of sluggish growth and deteriorating public finances.

Second, the Bank of England has been actively selling its holdings of government bonds, reversing the previous policy known as “quantitative easing” (QE), and doing so more aggressively than other central banks.

The Bank itself has said that the new policy of “quantitative tightening” (QT) may have added as much as 0.25 percentage points to 10-year gilt yields. This additional selling is especially damaging at a time when there is less demand from defined-benefit pension funds, who traditionally have been big buyers of longer-dated government bonds. In turn, this helps to explain the relatively large rise in the yields on 30-year gilts.

Third, there are fears that higher inflation in the UK will keep official interest rates higher for longer too, while adding to the cost of inflation-index-linked borrowing (of which the UK has a relatively large amount). By contrast, yields in the euro area and Japan are anchored by relatively low inflation and the relatively low interest rates set by the European Central Bank and the Bank of Japan.

This does not mean that a full-blown debt crisis is imminent in the UK, or even inevitable. The increase in bond yields only affects the cost of new borrowing, not that of existing debt, which provides at least some breathing space. The average time remaining before each conventional gilt has to be refinanced is more than 13 years, with only 16% falling due in the next three years. The average left on index-linked bonds is even longer, at more than 17 years.

It is worth stressing, too, that the rise in government bond yields has been relatively orderly, with little contagion to other markets. Investors have been demanding higher returns to compensate for higher risks, but there has been no shortage of buyers at the lower prices. And when more cash is required, the government’s Debt Management Office is now selling more gilts with shorter maturities to avoid having to pay the higher interest rates on longer-dated bonds.

So far, this episode is therefore still different from the crisis in the wake of the mini-Budget in September 2022. The sell-off in gilts then was accompanied by a panic in the mortgage market, prompting residential lending to dry up. The sharp falls in the prices of gilts also caused immediate problems for some pension funds. The pound slumped too.

Is a 1970s-style debt crisis looming?

The UK is not yet on the cusp of an IMF bailout, either. Admittedly, an increasing number of commentators are warning of a “1970s-style debt crisis” unless the chancellor changes course.

These voices include three leading economists – Jagjit Chadha, Andrew Sentance and Willem Buiter – who are not the usual suspects and whose views should be taken seriously.

Chadha and others have also made the reasonable point that IMF involvement might enhance the credibility of the fiscal framework and restore some market confidence, thus attracting more private capital, which could dwarf the limited resources available to the IMF.

Nonetheless, the circumstances now are also different from the 1970s. The bailout from the IMF in 1976 was a US dollar loan. This was mainly used to pay back other countries that had lent foreign currencies to the UK government as it attempted to prop up the pound. That is not the problem now.

The UK is not facing a sterling crisis (at least, not yet) and the government would be right to let the pound fall if it were. Any IMF bailout would also come with such punitive conditions that it would be politically unacceptable, including big cuts in public spending.

Put another way, if the UK government were willing to take these tough decisions, we would not need the IMF in the first place. An IMF-imposed austerity programme would surely be the end for both Rachel Reeves and Keir Starmer, especially with the emerging threat from Jeremy Corbyn’s new far-left party. The markets would not necessarily be reassured.

More positively, the prospects for the UK are still better than in the 1970s – in some respects. The economy shrank by about 4% in total in 1974 and 1975, unemployment rose sharply (from a low of 3.7% in 1974 to a peak of 11.8% 10 years later), and both inflation (peaking at 24% in 1975) and interest rates (the Bank rate hit 15% in 1976) were much higher.

Averting a debt crisis: try the stop-gaps first

Finally, there are other things the authorities might try before calling in the IMF. In an emergency, the government could borrow short-term funds through an existing overdraft facility at the Bank of England, known as the “Ways and Means” (W&M).

There is a recent precedent; an agreement in April 2020 allowed for more use of the W&M during Covid, although this was never actually needed.

And if the bond markets did become disorderly, the Bank of England could step in to buy gilts again on a temporary basis – as it did (remarkably successfully) in September 2022.

But this is only partially reassuring. These stop-gaps could backfire if they are seen to underline just how big a mess the public finances are in, and if the government does not use the breathing space to tackle the underlying problems. Less positively, the public finances are now in a bigger mess than in the 1970s.

The annual budget deficit was similar (averaging 6% of GDP in 1974 and 1975), but the stock of debt was far lower (about 48% of GDP, compared with 96% now). Another new risk is that roughly a quarter of government debt is now linked directed to the rate of inflation.

In any event, the latest bond-market wobbles could hardly have come at a worse time. In a few weeks’ time, the Office for Budget Responsibility (OBR) will start to crunch the numbers for the Budget.

Importantly, the OBR’s forecasts will be based on whatever the markets are assuming about the path of interest rates over the next five years. These assumptions could therefore eat further into any remaining headroom against the government’s fiscal rules or, more likely, make the existing shortfall even larger.

In turn this could prompt Reeves to announce even larger increases in taxes, hitting consumer and business confidence hard and having an immediate impact on economic activity.

It is also still possible that the nervousness of bond investors will spill over into other markets, including equities. The property market already appears to have stalled again.

Sterling is especially vulnerable too if the loss of international confidence becomes a rout, which again could have an immediate impact on other asset prices, on inflation, and on the real economy.

At the moment, the risk of a sterling crisis is being minimised by the fact that other countries are in trouble, too. But that could easily change if the UK were seen as an even bigger outlier.

Time may be on the government's side

The main hope now is that conditions may improve before the Budget itself on 26 November. The relatively late timing has raised fears that a longer period of speculation and uncertainty will undermine confidence further. But there could be some advantages too.

Perhaps most obviously, the delay leaves more time for global bond markets to calm down, taking some of the pressure off borrowing costs in the UK.

This could also work in the opposite direction if there is more bad news from elsewhere, perhaps the US (for example, higher tariffs could finally feed through into consumer price inflation, exacerbating the tensions between Donald Trump and the Federal Reserve), or from France, or from half a dozen other countries where concerns about fiscal sustainability are also growing.

Fortunately, an improvement in global sentiment is not the only potential upside from having a late Budget. The second positive is that the UK government would have more time to find some new savings on the welfare bill to replace the £6 billion lost to the U-turns on working-age benefits and winter-fuel payments. These savings would still have to be acceptable to Labour MPs, but the government would have longer to get the politics right.

The government will also have extra time to persuade the OBR that the planned increases in public investment and supply-side reforms will boost the productive potential of the economy.

Indeed, the growth assumptions will be even more important than the assumptions about inflation and interest rates. The increase in gilt yields since the OBR’s forecast for the Spring Statement might add about £5 billion to the shortfall that has to be filled by spending cuts or tax increases. But this shortfall could swell to £50 billion if the OBR adopts the same pessimistic forecasts for productivity and growth as those used recently by the National Institute of Economic and Social Research (NIESR).

Fortunately, NIESR’s £50 billion is an outlier. It is still possible that the chancellor will be able to keep the fresh pain down to around £20 billion, with at least £5 billion of that coming from welfare savings rather than tax increases.

That might be the least bad outcome, and perhaps even a relief to some. But there can be little doubt that the UK is in the early stages of a crisis that could play out in many different ways – with or without the involvement of the IMF.

Julian Jessop is an independent economist.

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The sale after 17 years of the last of the government’s stake in NatWest has led some to claim that this was good news for the banking sector. The stock overhang has been removed, and the sale has got the state off its back, they say.

Don’t count on it. Instead, this could herald open season for the government on the UK’s banks, meaning higher taxes, more regulation and the endorsement of new crackpot compensation schemes dreamed up by disgruntled consumers and grievance-chasing lawyers.

More insidious still is the cunning plan by Reform to save £35 billion by the Bank of England (BoE) ceasing to pay interest on deposits held at the central bank by UK lenders. This proposal is so deluded that, almost inevitably, the government will adopt it.

The banks would seek to mitigate the loss of income by removing their deposits from the BoE and either investing in short-term gilts or lending to the private sector at whatever interest rate they could get. The former would bring down yields in the short term, helping the government to finance its borrowing requirement; the latter would reduce private sector borrowing costs. The snag is that the BoE would lose control of market interest rates.

The stimulus to monetary growth would create a spiral of rising inflation and a weakening currency, with the Bank of England and government powerless to stop it. Banks would be trebly hit: by the loss of revenue, the boom leading to bust with multiple insolvencies, and by the lower valuation of their shares in foreign currency terms.

Investors should instead consider the Polar Capital Global Financials Trust (LSE: PCFT). Almost 90% of the trust’s assets are invested outside the UK: 40% in banks (JPMorgan is the largest holding at 7%), 18% in insurance and 38% in financial services such as Mastercard and Visa. The portfolio has returned 19% over one year, 54% over three and 118% over five. Since NatWest, Lloyds and Barclays have all performed considerably better than that, now might be a good time to switch out of UK financials and into PCFT.

Moving away from bank stocks

PCFT managers Nick Brind and George Barrow have significantly reduced their exposure to banks in the recent years – their allocation to the sector was 59% of the portfolio three years ago and 49% two years ago. “Some banks are great businesses,” says Brind, “but we see better opportunities elsewhere.”

“The sector has performed very well and valuations have risen but earnings have grown faster than the market,” he says. “When we started, 12 years ago, the sector was trading on a 15% discount to the broader market; now it’s on 12 times earnings or 11 times excluding the data-service companies such as Visa and Mastercard. This is a 30% discount to the market.”

Financials have been widely distrusted by investors since the 2008 financial crisis, but “banks have been forced to clean up their act, and a lot of risk has been shifted off-balance sheet. The financial system has much more capital and liquidity, household and corporate balance sheets have seen a significant strengthening, yet the sector remains unloved.”

The sector would benefit from lower interest rates and lighter-touch regulation in the US and Europe. “We believe it would take a severely negative macroeconomic scenario to end the sector’s relative outperformance,” says Brind.

PCFT is trading at a 5% discount to net asset value (NAV). It offers the chance to redeem at NAV every five years, and the latest redemption cut the market cap by more than 40% to £350 million. Fees have been reduced, and a revised dividend policy pays 4% of NAV yearly.

An equally compelling investment worth considering is Polar Capital’s Global Insurance Fund, which has returned 98% over five years and 223% over 10.

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What’s the beef between Jerome Powell and Donald Trump?

US president Donald Trump wants a looser monetary policy – lower interest rates – to get the economy growing and mitigate the impact of the ballooning US federal debt. Jerome Powell, the chairman of the Federal Reserve, the US central bank, sees his job as to resist that political pressure and is determined to carry on targeting inflation as the best way of ensuring long-term economic stability and growth. It’s an age-old (or at least decades-old) story of tension between elected leaders and “independent” central bankers. But in the case of Trump and Powell, there’s genuine animus and the stakes are exceptionally high. Trump himself appointed Powell (a Republican ex-investment banker) to the job as Federal Reserve chairman in his first term in 2018. But Trump quickly regretted his decision due to Powell’s refusal to bow to political pressure. Within months, the president was publicly attacking Powell as “crazy” for continuing to gradually raise interest rates and unwind America’s quantitative easing.

Why not sack Jerome Powell?

A president can’t sack a Fed chair over differences on monetary policy. He can only sack them “for cause” – meaning malfeasance of some kind. Powell’s term as the Fed governor (though not as a board member, should he choose to stay on) ends in May next year, at which point Trump will no doubt try to find someone more malleable. In the meantime, Trump’s undermining of Powell has become toxic. The Fed has kept borrowing costs on hold at between 4.25% and 4.5% this year, even as other central banks have cut. That’s partly, by Powell’s own account, due to April’s “liberation day” tariffs and their upward impact on US inflation forecasts. Were it not for that fresh negative factor, the Fed “would probably have cut rates [again] by now”, said Powell last month. In response, Trump has become increasingly abusive – attacking Powell as a “numbskull”and “complete moron”.

Why is Trump so angry?

Because the political stakes are unusually high, the US federal debt is unusually high and Trump is an unusual president. “It’s pretty universal having a president who wants lower rates,” says Don Kohn, a former Fed vice-chair. “What’s unprecedented is [Trump] doesn’t want lower rates to goose the economy, [for him] it’s about lowering the cost of the debt. That’s worrisome because keying monetary policy to relieving budget pressures is a sure track towards higher inflation.” Last month, Trump claimed Powell’s reluctance to cut rates – “at least three points too high”, says Trump – was “costing the US $360 billion a percentage point in refinancing costs”. That’s a trillion dollars worth of anger, which has expressed itself in mounting public frustration, including presidential musings on whether to fire Powell, and a tense on-camera spat over the cost of Fed renovations – as Trump apparently hunts for a just “cause” to replace the governor.

Why does all this matter?

Because it has undermined market confidence in the independence of the Fed and the stability of US policymaking – sending the dollar sharply lower this year and making a bond-market crisis more likely, as investors (fearing their loans would be repaid in a depreciated currency) demand higher interest rates. Last week, in a rare rebuke – albeit one that didn’t name the US, its biggest shareholder – the International Monetary Fund warned that undermining central-bank independence risked triggering a debt crisis and that independent monetary policy is “a cornerstone of macroeconomic, monetary and financial stability”. In the case of the US, that matters to all of us. An increase in US credit risk due to concerns regarding fiscal sustainability could make financial markets excessively volatile.

Are central banks independent?

Over the past half-century it’s become the norm for central banks to be at least nominally independent in rich-world economies. The idea is that politicians can’t be trusted to run monetary policy because they are too influenced by short-term political considerations. Giving the Bank of England independence was first mooted by Nigel Lawson in the 1980s and finally happened in 1997 under Gordon Brown. By contrast, Germany’s Bundesbank, the first central bank to gain full operational independence (in 1957), was central to the Federal Republic’s relative price stability and economic outperformance. In the US, the Fed has notionally been independent since 1951. But the institution remains haunted by the blunder of chairman Arthur Burns, who was pressured by president Richard Nixon to cut interest rates in the run-up to the 1972 election – ultimately leading to disastrous “stagflation”.

Independence is better, then?

It’s simply a means to deliver superior price stability and economic performance. There is historic evidence, dating from the 1980s onwards, that independent central banks tend to foster greater price stability. But the charge that independence removes democratic accountability became more potent in the wake of the 2007-2008 financial crisis, as banks became more powerful and pursued highly politicised and contentious strategies such as quantitative easing. There has also been much less consensus over the purpose of monetary policy in an era of low inflation and low growth. Why target inflation when the real issue is stagnation? Central banks also struggled to cope with the post-pandemic inflationary shock, further undermining faith in their technocratic omniscience.

So Trump is right?

As with many of his views, there’s a kernel of truth. But any attempt to curb the Federal Reserve’s independence – especially when it comes to rate-setting – would be very bad news for financial markets. As John Authers puts it on Bloomberg, “Independence may be the worst form of central banking – except for all the others.”

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Britain’s chancellor Rachel Reeves is facing at least as much risk from her parliamentary colleagues as she is from gilt markets. Upon delivering the Spring Statement in March, she introduced welfare reforms to ensure the Office for Budget Responsibility (OBR) would confirm she had met her fiscal rules.

But tightening the criteria for disability benefits was a step too far for many Labour MPs, who rebelled once the welfare reforms came to a vote. The government only managed to pass the bill by gutting its substantive fiscal savings, leaving Reeves with an extra £5 billion to find. She broke down in tears, gilt markets wobbled, and a huge fiscal black hole looms.

Tax hikes cannot fill the gap without endangering growth and breaking a manifesto pledge. The fiscal and political constraints are now so great that the chancellor, a keen chess player, must recognise she is in zugzwang: there are no good moves left.

One year on from a historic landslide, it seems almost impossible to contemplate that the government is unable to command a majority in parliament. And yet the welfare rebellion demonstrates the party is unable to accept the fiscal reality.

Debt interest payments total £100 billion a year, almost twice the amount spent on defence and not far off the education budget. This was her inheritance. Such is the debt albatross slung around the neck of the low-growth UK economy.

The chancellor’s first decisions have compounded the problem. Her attempts to boost growth, such as increasing public investment and relaxing planning regulations, only pay off in the long term, whereas the increase in the minimum wage and employers’ national insurance had an immediate effect on business hiring and confidence.

Is there a third way for Rachel Reeves?

But this is mere tinkering when the solution at its heart is a question of political philosophy. Would tax cuts and a small state boost growth, or must the government deliver tax and spend? Liz Truss famously tried part of the former and lost her job – but with government borrowing and the UK tax burden already at record highs, the latter strategy would be an even bigger gamble.

Reeves has tried to plough a third way, promising not to raise the big three taxes of income tax, national insurance and VAT while spending only to invest. The compromise has not worked. Rather than expanding growth, the chancellor has been forced into ever tighter corners.

The fiscal constraint has led to manoeuvres that have confounded even her own electorate. It’s unlikely Labour voters wanted to reduce benefits for the old, the disabled and children with special needs. This is a government with a majority but without a mandate for the actions that the chancellor decided to take.

The lack of a mandate is exactly what caused so many problems for Liz Truss: if Truss had won a general election on a platform to cut spending and taxes, the government might have been able to pursue such policies with impunity, à la Donald Trump.

Instead, UK voters punished the government in the local elections. The party is slumping in the opinion polls, having lost a third of its support in less than a year. Labour MPs are wondering what they signed up for. Many of them are entering parliament for the first time, scarred by 14 years of Conservative rule.

Anything that smacks of “austerity” must be repudiated. The welfare reforms at which so many of them baulked were only going to reduce the growth of disability spending, not cut it. That was a step too far for enough Labour MPs that the government could no longer rely on its majority.

Our analysis of each Labour MP showed that opposition to the welfare reforms extended well beyond the usual troublemakers. We ranked each MP by a number of quantitative criteria such as their voting record, incumbency and ministerial status to create a ranking for how likely they were to rebel. Even some of those with a relatively neutral score voted against the bill, such was the depth of opposition.

This is the start of an ongoing problem that will stymie the government’s agenda. The rebels succeeded and will now be emboldened. The left of the Labour Party is the political tail wagging the fiscal dog. Hence, there are renewed calls for the government to consider a wealth tax. As much as the gilt market is becalmed by the expectation of higher taxes plugging the fiscal gap, anything that dissuades capital and wealth from flowing into British assets would only serve to make the hole even bigger.

The latest Fiscal Risks and Sustainability report from the OBR has highlighted the dependence of the gilt market on the kindness of strangers. Overseas holders of gilts have become an increasing source of demand for the UK’s government debt. Their share of total gilt holdings has risen from 19% in 1998-1999 to 31% in 2023-2024.

If tax increases are thought to harm growth or hurt capital, foreign holders will need a higher yield or lower sterling to compensate them for the increased risk. All of this adds up to a winter of discontent for gilts. The Budget can’t be tough enough to please financial markets while being loose enough to please Labour MPs. The political and fiscal constraints upon the chancellor have combined to leave her in zugzwang, where no move confers an advantage upon her position. Swapping the pieces on the board won’t improve matters either. Les jeux sont faits.

Helen Thomas is the founder and CEO of Blonde Money, a macroeconomic consultancy.

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“Sire… worse than a crime, you have committed an error,” said Charles Maurice de Talleyrand-Périgord. A crime is whatever the feds say it is. Often not what you think it ought to be. But an error is different. It is a left turn when you should have turned right. It is forgetting your wife’s birthday. It is a budget deficit, when you should have been running a surplus.

In the Big, Bad, Budget Abomination, for example, there are two huge errors. The obvious one: they increased the deficit. They chose more spending, not less – even more money they don’t have on programmes they don’t need. And they are doing it on such a large scale – with $2 trillion deficits – it is sure to blow up the entire US financial system.

We all know you can’t spend more than you make for long. But some people delude themselves that we’ll “grow our way” out of the debt trap. As we’ve seen, in the light of federal policies, such growth is less and less likely. As Fortune points out, the US may see more than 500,000 people emigrate from the country as a result of Donald Trump’s aggressive deportation campaign. The hit to the US labour force is likely to shrink the country’s GDP.

Deficits will also gobble up the supply of capital. “As government spending increases, the less productive public sector absorbs more labour and resources, starving the more productive private sector of these critical inputs,” as Seeking Alpha points out. The predominant view is that, although the feds’ deficits are clearly a mistake, it will take many years for the harm to show up. So, the consequences, such as they are, will probably fall on our children and grandchildren, not on ourselves. And since none of us knows the future, why worry about something that may or may not actually happen sometime in the distant tomorrow?

Debt deniers and the Republican "spendfest"

Yet the iceberg is dead ahead and the danger looms closer. Inflation rose in June, for the second month in a row. Whether this marks the beginning of large price increases or not, we don’t know. But it might be a good idea to keep an eye on the lifeboats, just in case.

Other debt-crisis deniers look to Japan for comfort. Except for the fact that their economy is shrinking (along with their population), a Fuji of debt – the biggest pile in the world – hasn’t seemed to bother them. But wait. Even there, the error is becoming more apparent. The yield on ten-year Japanese government bonds has hit 1.595%, the highest since October 2008. The Japanese can do maths. At 250% of GDP, even a small increase in interest rates has a devastating effect on government finances. The government must borrow to cover the interest payments, which widens the deficit, increases the debt and raises the cost of interest.

Back in the US, the Republicans’ “spendfest” goes on and the errors multiply. Not only are they spending too much, they are claiming to spend too little. After all, if huge deficits don’t really matter, why try to save money on medical care for those who need it?“GOP lawmakers are warning that slashing spending on Medicaid and food assistance will cost the party seats in the mid-terms – threatening their razor-thin House majority – by kicking millions of Americans off safety-net programmes,” says The Hill. The poor lawmakers had to decide. Which error, which sin, which mistake to make. Being fair about it, they make them all.

For more from Bill, see bonnerprivateresearch.com

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UK gilt yields summary

• UK borrowing costs have surged to the highest level since the global financial crisis.
• Some are blaming the Autumn Budget for the rise in yields, but borrowing costs are also rising in the US in response to heightened concerns about inflation.
• Strong US jobs data pushed gilt yields higher before surprise inflation dip reversed the trend.

Scroll for analysis from the team at MoneyWeek.

Good morning, and welcome to MoneyWeek’s live blog covering today’s big financial news: the spike in gilt yields that threatens to upend chancellor Rachel Reeves’ Autumn Budget just months after it was announced.

Dan McEvoy and Katie Williams here to take you through the news as it develops.

The background

Gilt yields – effectively, the interest rate the UK government pays on its debt – have skyrocketed over the last two days to their highest level since the financial crisis.

This puts chancellor Rachel Reeves in a tight spot. Her Autumn Budget – barely two months old – risks unravelling as the costs of servicing UK government debt soar.

Shadow chancellor Mel Stride has called Reeves to address the House of Commons on the crisis this morning. However, at the time of writing, it looks as though Reeves is pressing ahead with a planned trade visit to China instead.

Why are gilt yields rising?

Unsurprisingly, politicians have traded barbs over who is to blame for the increase in gilt yields in Parliament this morning.

Conservative MPs blamed Reeves’ Budget for spooking bond markets, while Labour MPs have attempted to push the blame back onto the previous Conservative government for running up the “black hole” that forced Reeves into tax rises.

Financial analysts also appear split on the matter.

Matthew Ryan, head of market strategy at Ebury, views the yields spike as “a damning indictment of Labour’s fiscal policies”. Ryan singles out the increase to employer NI contributions “which businesses have already warned will lead to higher prices and a worsening in labour market conditions”.

Laith Khalaf, on the other hand, points to the fact that bond yields have been rising in the US and the UK over recent months, and thinks that this week’s spike is more due to the potential impact of Donald Trump’s incoming presidency.

“The fact yields are rising on both sides of the Atlantic does suggest the new year has brought with it a focus on the incoming US president, and the potential for his trade and immigration policies to be inflationary,” says Khalaf.

Mike Riddell, portfolio manager, Fidelity International, seems to agree: “A common conclusion is to point fingers at the government. But this would miss the point; it is mainly a global fixed income story. UK gilt yields are broadly moving with US Treasuries.” He also points to similar moves in long-dated German government bonds over the past month.

Treasury response

A spokesperson for HMT responded to MoneyWeek with the following statement:

“No one should be under any doubt that meeting the fiscal rules is non-negotiable and the Government will have an iron grip on the public finances.

"UK debt is the second lowest in the G7 and only the OBR’s forecast can accurately predict how much headroom the government has – anything else is pure speculation.

“Kick-starting economic growth is the number one mission of this Government as we deliver on our Plan for Change. Over the coming weeks and months, the Chancellor will leave no stone unturned in her determination to deliver economic growth and fight for working people.”

The Treasury also iterated that “the current budget deficit is forecast to be £55.5 billion in 2024-25. From then, it improves in every year until 2027-28 when the current budget is in surplus”.

The spokesperson said that Reeves will “deliver a speech in the coming weeks on the Government’s economic strategy and plan for growth”, but did not respond to a question on whether or not she will address Parliament on the matter today. This appears unlikely given her scheduled trip to China.

Taxes to increase?

The fear is that increased borrowing costs will force the government either to raise taxes, or to cut back on public spending in response, having just raised taxes in the Autumn Budget in order to cover the so-called fiscal black hole.

“Higher yields put pressure on government finances and increase the risk that Reeves will come back with another tax raising Budget,” says Khalaf.

Over the long term this could impact the UK’s growth prospects.

“Weak demand for UK debt raises the risk of either government spending cuts or further tax hikes to balance the country’s finances, neither of which would be positive for growth,” says Ryan.

An opportunity for bond investors?

Is the latest spike in yields good or bad for bond investors? It largely depends on whether you are an existing bondholder or someone eyeing up new opportunities in the market.

Bond yields and bond prices have an inverse relationship, so when one rises, the other falls. Investors have been selling UK government bonds recently in response to the latest risks, and this has pushed yields up.

Those with gilt investments will have experienced some recent losses as a result of the latest developments. “The typical gilt fund is down 2.5% in the last three months, while the typical pension lifestyling fund is down 4.4%,” according to Khalaf.

The flipside is that the yields spike is creating income opportunities. “Fresh bond investors might be licking their lips as yields rise and they are able to lock into higher rates,” Khalaf adds.

2022 all over again?

It doesn’t take a particularly long memory for today’s events to recall the last time rising gilt yields threw the UK government into chaos.

Liz Truss’s infamous ‘mini-budget’ of September 2022 sent gilt yields up 1.2% within days of its announcement. This ultimately forced Truss to resign.

“Today, the UK’s demons are back, driven by heightened fiscal concerns – evoking memories of Liz Truss’s chaotic 'mini-budget’ days,” says Ipek Ozkardeskaya, senior analyst at Swissquote Bank. “Back then, markets lost confidence in the government’s spending plans, triggering an aggressive selloff that forced the BoE to intervene.”

However, George Saravelos, global head of FX research at Deutsche Bank, thinks the two gilt yield crises are distinct from one another.

“The 2022 crisis was self-inflicted,” he says. “It was a UK-driven policy shock. The easiest way to see this is that gilt moves back then completely decoupled from other markets and idiosyncratically sold off.

“This time round, all gilts are doing is mirroring US treasuries. The most straightforward way to demonstrate this is that the 10-year UST - Gilt spread is moving sideways and is exactly where it was six months ago.”

The bad news, though, is that “precisely because recent market volatility is not self-inflicted there is no easy way out”.

Saravelos argues that because the UK relies relatively heavily on foreign financing for its domestic debt, gilts are more exposed than other developed economies’ bonds to US Treasury sell-offs.

“The chancellor and central bank have an important job to do,” says Saravelos. “The Bank of England needs to maintain the credibility of the inflation target. The chancellor needs to signal sensitivity to the worsening global environment by potentially paring back some spending. Both need to avoid any signal of fiscal dominance.

“But beyond a few tweaks here and there, it is largely the currency that will do the work of stabilizing the bond market combined with an eventual peak of US yields.”

Mortgage rates could rise thanks to surge in gilt yields

When setting mortgage rates, lenders pay close attention to a range of factors including swap rates. These are closely linked to gilt yields. As a result, the latest increase in gilt yields does not bode well for those hoping to see mortgage rates fall further.

The average two-year fixed mortgage rate is currently 5.47%, according to comparison site Moneyfacts. The average five-year deal is 5.25%.

What do higher gilt yields mean for the pound?

It’s a pretty miserable time for sterling.

“Typically, higher inflation expectations or a hawkish adjustment to the BoE policy stance drive yields higher, and that is bullish for the pound,” says Kyle Chapman, FX Markets Analyst at Ballinger Group. “In this case, the move is driven not by the macro data, but by heavy gilt supply, concerns about the UK government’s debt sustainability, and the inflationary impacts of the extra fiscal spending in the pipeline.”

This has seen the pound fall by fractionally under 1% against the dollar earlier this morning, though it has since recovered some of these losses.

As Saravelos says, though, the pound’s fall is an important mechanism through which the gilt market can stabilise.

Every cloud has a gold lining?

While the surge in gilt yields has caused a headache for the government and some investors, it has meant good news for the gold price. Up 37.5% compared to this time last year, the gold price is now £2,172 per Troy ounce – a new GBP record.

“Because gold pays no interest, it usually falls in price when bond yields rise,” says BullionVault director of research Adrian Ash. “Gold rising together with government borrowing costs signals how uneasy the markets are becoming over the UK's budget deficits and long-term debt.”

Gilts and Treasuries joined at the hip

Underscoring the point about gilts and Treasuries (the US equivalent) is this chart from AJ Bell, based on Refinitv data:

That’s not to say that the ramifications are the same, though.

“The US has the benefit of being the world’s reserve currency, which underpins demand for dollar denominated assets such as US Treasury bonds,” says Laith Khalaf, head of investment analysis at AJ Bell. “Here in the UK, higher yields put pressure on government finances and increase the risk that Reeves will come back with another tax raising Budget.”

Are higher gilt yields good news for annuity rates?

Many savers who are approaching retirement have a large allocation to bonds in their portfolio – part of their de-risking strategy. Their portfolios may have suffered losses recently as a result of the selloff in gilt markets.

However, there could be some good news for older savers on the cusp of purchasing an annuity with their pension savings.

“The surge in gilt yields could push up annuity rates in the coming weeks,” says Helen Morrissey, head of retirement analysis at Hargreaves Lansdown. “It would add a further boost to a market that has enjoyed enormous growth in recent years.”

She explains that a 65 year-old with a £100,000 pension could currently get up to £7,235 per year from a single life level annuity with a five year guarantee. “We could see this increase further from here,” she adds.

Do higher gilt yields point towards stagflation?

The nightmare scenario is that elevated UK government debt hinders the government’s ability to kickstart growth in the economy, and coincides with an inflationary environment – a combination that economists call ‘stagflation’.

“There is also particular concern brewing about stagflation taking hold, given that inflation has been creeping up and pay growth is still hot, while the economy has been stagnating,” says Susannah Streeter, head of money and markets, Hargreaves Lansdown. “It’s unclear to what extent the UK government’s investment in infrastructure will provide a boost to growth over the longer term.”

Streeter adds: “it seems appetite to buy long-term dated UK government debt has fallen amid the increased uncertainty gripping global bond markets.”

Mortgage costs unlikely to fall any time soon

The start of the year can sometimes be a good time to shop around for a mortgage deal. That was certainly the case last year, when lenders sparked a pricing war as they jostled with one another to attract customers with lower rates.

The start of 2025 looks a little different, though. Ben Thompson, deputy chief executive at Mortgage Advice Bureau, expects mortgage rates to “rise in the near term at least”.

He says: “Some of the factors underlying the recent spike may well soften soon, but it has felt for a while that inflation would persist at a slightly higher level than targeted and as such the cost of borrowing would remain broadly at current levels and isn’t about to fall meaningfully anytime soon.

“What we have seen is the market gradually adjust to a higher rate environment in part helped by wage growth and that means that those who have waited to buy or move home for a few years will now just want to commit and get on with it, as opposed to waiting for mortgage rates to drop much further.”

“We think that bonds will recover before long”

The selloff in the UK government bond market has sparked further criticism of Reeves’ Autumn Budget this week. However, experts at consultancy Capital Economics have called the latest developments a “global bond market storm in a British teacup”.

“We think that bonds will recover before long, with yields falling back more in the UK than elsewhere,” says Hubert de Barochez, senior markets economist at the consultancy.

“One reason is that we expect Trump to fail to cut taxes as much as planned, and therefore that worries over US public finances will abate a bit,” he adds. “What’s more, with inflation near to target in most places, central banks have more room to cut rates if necessary.”

Although UK markets are only pricing in one or two base rate cuts in 2025, most economists think this stance is overly cautious. Capital Economics thinks inflation will fall more quickly than currently forecast and, as a result, expects the base rate to reach 3.5% by early 2026.

“This is why we forecast the 10-year gilt yield to fall back to 4.0% by the end of the year, from roughly 4.8% now,” de Barochez explains.

That concludes our coverage of the UK gilt market today. Thank you for following along with us. We will be back with more live analysis on markets, inflation and interest rates in the coming weeks, with a special focus on the US in the lead-up to Trump’s return to office.

Good morning, and welcome back to our live coverage of the ongoing gilt yields story.

Dan and Katie here, bringing you live coverage and analysis throughout the day.

Eyes on US jobs data as gilt yields edge upwards

10 year gilt yields have crept slightly upwards this morning, though are still below the 4.93% peak that sparked Parliamentary panic yesterday.

US jobs data being released this afternoon is likely to be the next big driver of gilt yield movements. With UK and US government bond yields moving in lockstep over recent months, macro changes in the US market will have a big impact on gilt yields this side of the pond too.

Reuters predicts that approximately 160,000 jobs will have been added during December, with the unemployment rate holding steady at around 4.2%. ING suggests that unemployment could tick up to 4.3%, but predicts that anything above the 150,000 jobs mark would “maintain upside momentum for yields”.

According to Reuters, stronger economic data than that could drive 10-year US government bond yields to a 13-month peak and strengthen the dollar.

A disaster in the making for Reeves?

Chancellor Rachel Reeves rejected calls to address Parliament over the gilt yields crisis yesterday, instead flying to China for a pre-planned three-day visit aimed at strengthening the UK’s trade and economic ties with the country.

While culture secretary Lisa Nandy has defended Reeves’ decision to go ahead with the trip, Reeves will surely have half her mind on the implications of the yield spike for her domestic agenda.

“The recent spike in government borrowing costs is in danger of turning into a political disaster for Rachel Reeves,” says Tom Selby, director of public policy at AJ Bell, “who will no doubt be sweating over the risk that any wiggle room in public finances could evaporate.”

Silver linings

While increased gilt yields are a potential nightmare for Reeves and the government, there are winners and losers as far as personal finances are concerned.

Rising gilt yields are bad news for borrowers, especially anyone with a mortgage that is pegged to the Bank of England base rate, says Selby.

“However, there will have been plenty of people cheering as gilt yields jumped to highs not seen since the 2007/08 financial crash,” he adds. “Returns on cash investments should be bolstered if gilt yields remain elevated, meaning people’s rainy-day savings should grow by more than previously expected. Companies administering defined benefit (DB) pension schemes could also see the value of their accounting liabilities substantially reduced, potentially swinging from a deficit to a surplus as a result.”

As mentioned yesterday, annuities are another potential winner from the gilt yields spike.

“Additional government spending, global uncertainty and higher taxes are all contributing to the recent increase in the cost of government borrowing,” says Nick Flynn, Retirement Income Director at Canada Life. “Whilst there are no cast iron guarantees, if this trend continues, then it’s a strong possibility that annuity rates will be maintained or even increase in 2025.”

READ MORE: Annuity rates rise 7% - is now a good time to buy an annuity?

Gilt yields and taxes

The challenge for Reeves is that the gilt yield increase could completely erase the £9.9 billion headroom contained in her Autumn Budget.

“In order to maintain fiscal credibility, there is a real chance that the Chancellor will be forced to announce at the fiscal update scheduled for 26th March lower government spending and/or higher taxes compared to existing plans,” says Ashley Webb, UK economist at Capital Economics.

While Webb feels that it is more likely Reeves would opt for tighter fiscal policy, he speculates that she might consider raising capital gains tax, alcohol and tobacco duties, air passenger duties or vehicle excise duty. Stamp duty and/or council tax increases on second homes could also be considered, but all of these taxes combined make up just 11% of total tax revenues.

This could potentially force Reeves into raising more tax revenue through, for example, reducing relief on pension contributions for high earners, scrapping the lifetime ISA, or extending the freeze on personal income tax thresholds.

Or, the government could expand the tax base by introducing VAT on products or services that are currently exempt – much as it has recently done with private schools.

All this assumes that Reeves won’t break Labour’s manifesto promise not to raise taxes on “working people” – which Webb calls “the government’s least politically palatable option”.

However, “it could easily raise a lot of revenue from only a small increase in the rate of VAT, income tax or national insurance tax. A 1 percentage point rise in each would raise £9.0bn, £7.3bn and £4.7bn respectively by 2026/27.

“Overall, while a lot can change between now and the fiscal update scheduled for 26th March,” says Webb.

When is US jobs data released?

Stay tuned: the US jobs data release is due at 8.30am US, 1.30pm time in the UK. The results are expected to be a key driver for gilt yields today.

BREAKING: Gilt yields up on strong US jobs data

Employers added 256,000 jobs to nonfarm payrolls in December, far more than the 153,000 FactSet analysts had expected.

Gilt yields have ticked upwards this afternoon as a result. Analysis to follow.

Yields on UK ten-year gilts have ticked up to 4.88% this afternoon, jumping from around 4.83% in the wake of that US jobs report.

Despite new jobs coming in above expectations, and unemployment unexpectedly falling to 4.1%, gilt yields haven’t (yet) exceeded yesterday’s highs.

Why has strong US jobs data pushed gilt yields higher?

In essence, strong US jobs means a strong US economy. A strong US economy means the Fed is less likely to cut interest rates, meaning rates in the country are likely to remain higher for longer.

“The larger-than-expected 256,000 gain in non-farm payrolls in December and drop back in the unemployment rate to 4.1% supports the Fed’s decision to slow the pace of rate cuts and has heightened speculation that the loosening cycle is already over, putting further upward pressure on Treasury yields,” says Thomas Ryan, North America economist at Capital Economics.

UK government bonds (gilts) have moved in tandem with US government bonds (Treasuries) over the past year. A strong US labour market therefore means higher gilt yields.

Market strop out intensifying

The jobs data has dented markets: the pound has fallen 0.58% today against the dollar, hitting a 14-month low, while the FTSE 100 is down 0.25%.

The S&P 500 – which was closed yesterday due to a national day of mourning for former US president Jimmy Carter – opened 0.47% below Wednesday’s close, and has fallen a further 0.35% since then.

“Worries about interest rates staying higher for longer have been reignited by this stronger-than-expected labour market data,” says Susannah Streeter, head of money and markets, Hargreaves Lansdown. “Sentiment has soured on equity markets and the bond market strop out is showing signs of intensifying.”

Further yield increases on the way?

“2025 has already seen notable increases in gilt and US Treasury yields,” says Hal Cook, senior investment analyst, Hargreaves Lansdown. “Today’s employment data out of the US is likely to cause further increases from here.

“The 10-year US Treasury yield spiked just under 10 basis points on the announcement. The 10-year UK gilt yield jumped 5 basis points at the same time. Volatility is expected to continue as the information is digested.”

Cook cautions, though, that US non-farm payroll data is often subject to significant revisions further down the road.

“Data for December, given the holiday season, could well see a big revision in future,” he says, “but that won’t stop markets reacting in the meantime.”

Bond market on the move

Gilt yields have fallen back again this afternoon, after spiking in the wake of the US jobs report.

As of 4pm, they’re sitting around the 4.84% level – a little above where they were prior to the US data release, but well below the afternoon peak.

There could be plenty more shifts in store, though, as Laith Khalaf, head of investment analysis at AJ Bell explains:

“The whole global bond market is on the move as investors shift their expectations for 2025. There is no one smoking gun which explains why bonds are selling off now, but a strong US jobs report is only going to add fuel to the fire. That points to a hot US economy and consequently less scope for rate cuts in the US, with Trump’s potential controls on immigration tightening the labour market even further.

“The US bond market exercises a heavy influence on UK gilts so we can expect some spillover to our own bond market. A strengthening dollar also puts upward pressure on UK inflation which is another byproduct of markets scaling back their forecasts for US interest rate cuts.”

Gilt yield increase is “a problem, not a crisis”

“This week’s leap in gilt yields creates more problems for the Chancellor and is an extra headwind for the economy. But it is not a crisis,” says Paul Dales, chief UK economist at Capital Economics.

While “it is always worrying when UK bond yields rise by more than yields elsewhere and the pound weakens”, Dales says that “the current situation is nothing like the sterling crisis of 1976 or the Liz Truss episode in 2022 as has been suggested”.

The recent moves have been smaller and lower; 30-year gilt yields have increased 70 basis points in the last six weeks, compared to 150 basis points in six days following the Truss mini-budget. That also saw the pound fall by 3%, compared to 1% this time around.

“That’s because the causes are different” says Dales. “The crises of 1976 and 2022 were due to loose fiscal policy at home that led to the government losing credibility. This time, the cause has been global, with the markets concluding that real interest rates need to be higher for longer everywhere to trim inflation.

“The UK has been hit harder than others mainly because of its reliance on overseas investors to fund its current account and government budget deficits. Indeed, the UK’s ‘twin deficits’ are bigger than every other G7 economy, and the euro-zone, except the US, which is seen as a safe haven as the dollar is the world’s reserve currency.

“So when global risk sentiment declines, the UK is more vulnerable to funds flowing to safer shores.”

That said, the gilt yields spike “does cause problems”. Capital Economics estimates that the increase in the debt interest payments will be sufficient to break the fiscal rules Rachel Reeves has previously set out. As discussed, that could force her into either new spending cuts and/or new tax rises – with the former of those “more likely”, according to Dales.

Time to buy bonds?

Does the rise in gilt yields present a bond buying opportunity?

“Bonds are very attractively priced at the moment”, Oliver Faizallah, head of fixed income research at Charles Stanley, tells MoneyWeek. The current climate – one in which inflation is relatively low and stable, while bond yields are high, is “as good a time as it’s ever been to buy bonds”.

He also explains that, while government bonds like gilts are traditionally allocated to the safer parts of a portfolio, high yield bonds can be thought of similarly to equities, and can form part of investors’ allocation to risk given their yields.

See our full explainer on why now might be a good time to invest in bonds.

That's all from us this week. Goodbye for now, but join us next week when we'll pick up the latest news and developments with the ongoing gilt rate story.

Gilt yields up Monday morning

Good morning, and welcome back to our live blog as we continue to keep an eye on the latest in gilt yields.

Yields on 10 year gilts have hit a new high this morning, hovering at around 4.9% as of 9am.

We’ll bring you all the latest updates and analysis as the situation unfolds.

Reeves issues China trade update

Having been called to address Parliament about the gilt yield crisis on Thursday, chancellor Rachel Reeves instead pressed ahead with a planned trade visit to China.

The treasury announced on Saturday that the visit has resulted to agreements to deepen economic cooperation between China and the UK, with the agreements worth an estimated £600 million to the UK over the next five years and a potential £1 billion over the longer term.

“The agreements we’ve reached show that pragmatic cooperation between the world’s largest economies can help us boost economic growth for the benefit of working people – a priority of our Plan for Change,” said Reeves.

“More widely, today is a platform for respectful and consistent future relations with China. One where we can be frank and open on areas where we disagree, protecting our values and security interests, and finding opportunities for safe trade and investment.”

Rumour mill still grinding

The government is clearly keen to broadcast the good news out of China, and for good reason.

Capital Economics estimated on 7 January (last Tuesday) that the rise in gilt yields had wiped out £8.9 billion of the £9.9 billion fiscal headroom that was built into the Autumn Budget. Yields have increased still further since then. There is a very real possibility that all of it will be gone by the time the Office for Budget Responsibility (OBR) revises its forecasts on 26 March.

“With the UK still in the eye of the storm of concern worrying bond markets, it’s set to keep the rumour mill grinding about difficult tax and spending decisions ahead for Keir Starmer’s government,” says Susannah Streeter, head of money and markets, Hargreaves Lansdown. “The government is attempting to wrest the narrative away from painfully high borrowing costs and a plunging pound.”

Part of this attempt involves prime minister Kier Starmer's initiative to invest heavily into AI, announced on Saturday.

The government is "going all out on an AI pitch with recommendations to unleash the power of the technology to help public services become more efficient and help boost growth via special development zones", says Streeter.

The gilt yield drama is playing out against a backdrop of the government desperately wanting to improve economic growth, and improving international trade and domestic productivity are seen as key levers for the government to pull.

Pound hits 14-month low

The gilt crisis has pushed the pound to a 14-month low against the US dollar. “The combination of a robust dollar and a weakening pound is accelerating the capital flight from sterling,” says Nigel Green, chief executive of advisory and asset management firm the deVere Group.

He adds that investors are “turning to safer currencies and assets, as the UK appears increasingly fragile in this turbulent environment”.

A weaker pound is bad news for UK businesses who rely heavily on imports, pushing their costs higher. It could also spell bad news for consumers if businesses look to pass higher costs on by putting their prices up.

Consumers are already staring down the barrel of cost increases this year after changes announced in the Autumn Budget. Chancellor Rachel Reeves hiked employer National Insurance contributions – a change that will kick in from April – in an attempt to balance the state’s books.

Many businesses plan to pass these higher staffing costs on to their customers. A survey from the British Chambers of Commerce, conducted after the Budget, found that 55% of firms plan to raise their prices in the next three months, up from a previous reading of 39%.

Oil prices put further upward pressure on bond yields

While gilt yields are currently correlated with US Treasury yields, movements of both are driven by inflation expectations. Inflation erodes the real value of bond yields, pushing prices down and yields up in response.

So, inflationary pressures on both sides of the pond are likely to contribute towards further increases in bond yields.

On that note, rising oil prices could push gilt yields still higher. Brent crude was trading above $81 per barrel today.

The increase “comes amid renewed concerns amid supplies of crude after the US slammed more sanctions on Russia”, says Streeter. “These are targeted at vessels and tankers, which is aimed at disrupting trade with China and India, leading to expectations of higher demand from suppliers in the Middle East”.

Annuity rates rise further

As anticipated, annuity rates have surged higher in the wake of the gilt market crisis. Annuity rates determine how much you can earn when you buy a guaranteed income in retirement. They are closely linked to long-term gilt yields. The higher the annuity rate, the higher your regular payout. The rate is locked in at the point of purchase.

“The latest data shows a 65-year-old with a £100,000 pension can now get up to £7,425 a year from a single life level annuity with a five-year guarantee,” says Helen Morrissey, head of retirement analysis at Hargreaves Lansdown. “This is up from £7,235 a year last week and up a whopping 48% on the £5,003 that was on offer this time three years ago.”

She adds that annuity rates could rise even further over the coming weeks, potentially hitting the highs seen in the aftermath of the mini-Budget.

Mortgage rates edge up - will they rise further?

Some mortgage lenders like Coventry Building Society, Virgin Money and TSB have hiked their rates, and experts warn that we could see more increases as the bond market turmoil continues.

So far, mortgage rates have only edged up slightly. According to data analyst Moneyfacts, the average two-year fixed mortgage rate is 5.48%, up from 5.47% on Friday. The average five-year deal is 5.26%, up from 5.25%.

Nicholas Mendes​​​​, mortgage technical manager at the broker John Charcol, tells MoneyWeek: "Increased government borrowing and ongoing economic uncertainty have pushed gilt yields higher, which in turn drives up swap rates. Lenders are absorbing these increased costs for now, but they can only do so for a limited time before being forced to adjust their mortgage products."

Frances Haque, chief economist at Santander UK, agrees that mortgage lenders “may well – in the short-term - nudge up pricing to reflect the higher swaps”.

Thankfully, there is no sign (so far) of the mortgage market panic that followed the 2022 mini-Budget.

In the wake of Liz Truss's mini-Budget, two and five-year fixed deals went up by more than a percentage point, and 1,700 lender products - 40% of the market at the time - disappeared from sale in the space of a week.

Yields spike sees investor gilt purchasing increase

Unlike in the wake of 2022’s infamous mini-budget, the current gilt selloff isn’t a sudden thing, but has been brewing steadily since the autumn.

Data from Hargreaves Lansdown shows that its clients took advantage of increasing yields during December, with gilt purchases through its platform increasing 33% year-over-year.

Last week – as gilt yields reached highs not seen since 2008 – gilt purchases reached their highest level in a week by Hargreaves Lansdown investors since October.

“Given the increase in yields, it’s not a surprise we are seeing a spike in gilt purchases,” said Hal Cook, senior investment analyst at Hargreaves Lansdown. “The yield on the 2-year gilt at the end of December was around 4.37% but is now pushing 4.6%. And it was nearer 4.2% at the start of December. For the 5-year gilt, the story is the same – it was yielding about 4.05% at the start of December, 4.33% at the end of December and nearer 4.65% today. Looking back to the end of 2023, the 2-year gilt yield was around 4% and the 5-year nearer 3.5%.”

That's all from us today. Thanks for following all our coverage of the gilt rates story as it unfolds. Stay tuned for future updates.

Reeves to address Parliament

Good morning, and welcome back to our live coverage of the gilt yield spike.

Today’s big news: chancellor Rachel Reeves will answer questions in the Commons today for the first time since returning from a trip to China, the timing of which was criticised by political opponents for coinciding with a week of volatility for the pound and soaring yields on UK bonds. She returned from her trip on Monday as concerns mounted that the government is in danger of failing to meet its own fiscal rules.

The pound regained its footing on Tuesday, after hitting fresh 14-month lows on Monday. Yields on 10-year gilts are presently hovering at around 4.87%, having peaked at 4.89% earlier this morning.

Will Rachel Reeves be sacked?

In the manner of a Premier League manager on a dire run of results, Rachel Reeves received the full backing of her boss prime minister Keir Starmer, yesterday – though only once the cameras were off. At an earlier televised press conference, he avoided making any firm guarantees about her future.

Speculation is rife that Reeves’ position as chancellor could be under threat. Both the Telegraph and the Independent are asking who could replace the chancellor if the situation doesn’t improve, while the Daily Star has revived its infamous lettuce that symbolised the demise of Liz Truss’s premiership.

Former shadow chancellor John McDonnell told the Today programme that further spending cuts would “be politically suicidal” for Reeves. The fiscal rules she set herself ahead of Labour’s election win appear to have boxed her into a corner.

Chancellor Rachel Reeves is expected to make a Commons statement about her visit to China after 12.30pm today, where she will no doubt face questions about the spike in gilt yields.

BREAKING: Reeves addressing Parliament

The chancellor's statement is essentially a rationale behind her decision to visit China last week, as gilt yields were spiking. Her opening speech is concentrating on the importance of the UK's trading relationship with China.

Her opening line stated that "growth is the number one mission of this Labour government".

The questions that follow, though, are likely to focus on the implications of higher borrowing costs on the UK economy and Reeves' economic policies.

Stride shifts focus to rising gilt yields

Shadow chancellor Mel Stride, unsurprisingly, used his opening statement to outline the economic turmoil that rising gilt yields have provoked.

"The pound has hit a 14-month low. Government borrowing costs are at their highest in 27 years... This is a crisis made in Downing Street," he asserted, before asking Reeves why she didn't address Parliament on the issue last week.

Stride finishes his opening statement by asking Reeves which of her promises she will break should the OBR judge that she has breached her fiscal rules in March.

"Wil she cancel promised spending? Will she ramp up borrowing? Or will she raise taxes yet again?"

The chancellor has reiterated her commitment to her fiscal rules. There hasn't been a direct response to the question of where she'll give way should the OBR rule in March that she's breached them.

However, when asked to rule out future spending cuts, Reeves replied "I'm not going to write five years' worth of budgets".

Gilt yields touch 4.9%

Gilt yields are moving relatively quickly while all this is going on. They fell from 4.89% to 4.86% just before 1.30pm, then rapidly jumped upwards to touch 4.9%.

These moves mirror US 10-year Treasury yields, though, so there is every chance that this is the main driver.

What can policymakers do about higher gilt yields?

The debate in Parliament is over (for now), but it highlighted some of the fault lines that the gilt yields increase has exposed. In effect, the government and the opposition benches both blamed each other for the increase in borrowing costs.

Naturally, this raises the question of what, if anything, Reeves or anyone else can now do to reduce them. According to analysis from Ruth Gregory, deputy chief UK economist at Capital Economics, Reeves has three options if her fiscal credibility is undermined:

1. Muddle through until the spending review on 26 March before announcing new tax/spending plans;
2. Announce potential tax increases before the spending review, in the event that the OBR finds she has broken her fiscal rules;
3. Front-run the spending review by pre-announcing lower public spending.

So far Reeves is sticking to option 1, but if her hand is forced into a change of approach Gregory thinks that 3 is more likely than 2 given yesterday’s commitment to be “ruthless” in spending review decisions.

It isn’t just Reeves with the power to respond, though. The Bank of England is another key component in the gilt yields mix.

“The situation is more straightforward for the Bank,” says Gregory. “If there are no clear signs of dislocation in the bond market, the Bank will wait until the next Monetary Policy Committee meeting on 6th February to cast its judgement on the outlook for interest rates.

“But should there be clear signs of significant dislocation in the bond markets… the Bank could say it will do whatever it takes to keep markets functioning smoothly and remind investors of the tools at its disposal. If that doesn’t work, it could take temporary and specific action to restore orderly market conditions, by buying gilts as it did in October 2022 and pausing Quantitative Tightening (QT) (i.e. selling gilts). QT would then continue once market functioning is restored.

“To be clear, this is a last resort. The Bank won’t pause or cancel QT unless there is clear dislocation in bond markets.”

Chancellor to fast-track growth strategy announcement

The BBC says the Chancellor is likely to bring forward the detail of a range of new growth strategies in the next few weeks as she promises to move “faster and further” on the economy.

It says she will deliver a major speech on the overall growth strategy before the end of the month.

Morgan Stanley: Short GBP positions highest since November

Investment bank Morgan Stanley has today published a research note highlighting that FX options pricing data in the week ending Friday 10 January showed investors are shorting the pound at levels not seen since November.

“Overall, Options data suggest that tactical investors are long USD (DXY), while being most short GBP and EUR,” said the note.

Since the start of the year, the pound has fallen roughly 3% against the dollar.

That's all on gilt yields for now. Thanks for following so far. We'll continue to follow the story here at MoneyWeek.

Be sure to check out our inflation live blog, as the latest UK CPI reading is released tomorrow morning.

BREAKING: gilt yields fall on surprise inflation dip

Good morning, and welcome back to our gilt yields live blog.

Yields on 10 year gilts have dropped to around 4.84% this morning – the lowest they’ve been so far this week.

The catalyst for the drop is an unexpected dip in UK core inflation during December, to 2.5%. Head over to our other live blog for more inflation information.

Respite for the government

Experts are in agreement that the lower-than-expected inflation reading provides welcome relief for chancellor Rachel Reeves, whose position in the government has been under pressure following rising gilt yields.

“A lower-than-expected inflation print will provide some relief to the recent sell off in gilts that we’ve seen so far this year,” says Mark Hicks, head of active savings, Hargreaves Lansdown.

“The surprise fall in inflation offers much-needed respite for the government after a tumultuous week for gilts,” says Myron Jobson, senior personal finance analyst at interactive investor.

Scott Gardner, investment strategist at J.P. Morgan owned digital wealth manager, Nutmeg, says “policymakers and treasury officials will be breathing a small sigh of relief as new data shows that inflation fell during the final month of 2024, beating market expectations.

“While it might be odd to be welcoming above target inflation, these results have grown in significance after an unstable start to the year for the pound and government borrowing,” he adds.

Gilt yields fall further

10 year gilts are now trading at around 4.82%, as they continue to fall through the morning. They dipped briefly below 4.80% earlier this morning.

UK inflation data has clearly calmed the gilt markets – for now. However, US inflation data will be released this afternoon. That will likely have a strong impact on gilt yields, given how closely they have been correlated with Treasuries in recent months.

Bad news for the pound?

Gilt yields have fallen back below 4.80%. Corks won’t yet be popping at the Treasury (especially as US inflation data later today could reverse the momentum), but there will be some deep sighs of relief.

However, while the inflation reading has calmed the gilt market, it’s not such good news for the pound, which has fallen slightly against the dollar this morning.

“The dip in headline inflation, particularly in services, will be welcomed by the Bank of England but leaves the pound vulnerable to further weakness as it reinforces the case for additional rate cuts,” says Nikos Tzabouras, senior financial writer at Tradu. “Such action is undoubtedly needed amid weak economic activity and soaring borrowing costs, especially with UK debt exceeding 98% of GDP.”

Further weakening of the pound could create its own inflationary momentum – but aggressive monetary easing appears unlikely at this stage, which has helped the pound find a degree of support.

Gilt yields fall further as US inflation data lands

US inflation rose to 2.9% during December, according to the latest release from the US Bureau of Labor Statistics. That’s slightly higher than FactSet analysts had expected, but matches expectations of economists polled by Reuters.

US Treasury yields have fallen on the announcement, and gilt yields have gone with them. 10 year gilt yields dipped as low as 4.72% before rebounding to 4.76%.

Government bond yields fall in US and UK

10-year gilt yields have continued to fall throughout the day. They even dipped below 4.7% this afternoon – though have now climbed back up to around 4.72%. It means that the gains over the last week that prompted Parliamentary panic have largely been reversed, though they will have to fall a good deal further before chancellor Rachel Reeves will be feeling comfortable about her borrowing plans.

10-year US Treasury (UST) yields have also fallen today, to around 4.67%.

“Following both the UK and US CPI numbers, there has been a bit of respite in both gilts and USTs,” says Oliver Faizallah, head of fixed income research at Charles Stanley.

Underscoring the fact that the government bond yield saga is far from over, though, Faizallah adds that “in the US, concerns around an inflationary government policy and large deficits will likely keep yields elevated for some time.”

That's all from us today. Thanks for following the blog - and if you haven't already done so, pop over to our other one covering today's inflation data to get up to speed there!

We'll keep you up to date with any further developments on gilt yields, which settled well down today at around 4.73%.

Good morning, and thanks for following our gilt yields blog over the last week or so.

10-year gilt yields have come down from their recent peak; today, they’re around 4.64%. They are still at generational highs, though, which will be a concern for the government.

We’re going to wrap our live coverage of the gilt yields story here for now. However, we’ll leave you with this explainer on what gilts are, and whether or not now is a good time to invest in them.

That’s far from the end of the live blogs on MoneyWeek though. Join us on Monday for live coverage of Donald Trump’s return to the White House.

Investors are set to get access to the primary gilt markets with investment platform Hargreaves Lansdown and will even be able to purchase and hold the bonds for free.

The primary gilt markets have long-been the preserve of institutional investors, with retail customers typically only able to access government bonds through secondary markets.

But in what is described as an industry-first, Hargreaves Lansdown users are to be given access to Debt Management Office (DMO) gilt auctions.

It comes as high interest rates and volatile equity markets have boosted the attractiveness of gilts, pushing yields higher.

“This is a ‘first’ for retail investors and gives them fair access to gilts in the primary market under favourable terms,” says Tim Jacobs, head of primary markets at Hargreaves Lansdown

“Muted equity markets and higher interest rates have led to a significant rise in client demand for fixed interest products.”

“The conventional auction process for Gilts is designed for institutions and may not be suitable for some retail investors. However, the new process invites retail investors to participate with favourable terms.”

How to access gilts through Hargreaves Lansdown

Investors can already purchase government bonds or gilts on many investment platforms including Hargreaves Lansdown.

But this has typically been limited to the secondary market, meaning investors may not get as good a deal if they had taken part in the initial auction process.

Hargreaves Lansdown says annual gilt trading volumes on its platform are up 315%.

Currently, more than 25,000 clients hold one of the 57 gilts available on the platform.

However, this has only been possible through secondary market purchases

Hargreaves Lansdown has worked with the DMO and Winterflood Securities to let retail investors participate in DMO auctions alongside institutions such as pension funds.

Under the arrangement, investors will be informed about an auction that will be made available through the Hargreaves Lansdown platform.

 The DMO will issue a prospectus for the gilt sale seven days in advance and retail clients will have until 4pm the day before the auction to apply. This means that Hargreaves Lansdown users will have six days to review the prospectus and submit an order.

At the point of application, clients will know the duration and coupon of the government bond.

They will not know the price until applications have closed and the auction has been completed.

It works similarly to an equity initial public offering that investors may be used to, where you are only informed about the price range and only get the actual price once applications close.

Hargreaves Lansdown clients will receive the average accepted price (AAP) which is determined during the auction.

What gilts are on offer?

The first gilt that investors can back will be a 4% Treasury Gilt 2031

The seven-year gilt matures on 22 October 2031.

Investors will still also be able to purchase gilts on the secondary market but would need to pay dealing fees.

How much will it cost to invest in government gilts?

There will be no dealing fees for buying government bonds through the auction process and Hargreaves Lansdown confirmed to MoneyWeek that other sales will have the same terms.

In contrast, you would need to pay dealing fees if you buy gilts on the secondary market.

The gilts can be held in an ISA, which has a 0.45% annual charge capped at £45 for this type of asset. There is also a 0.45% annual fee for a self-invested personal pension, capped at £200 per year. 

Most clients purchase gilts in their fund and share account, says Hargreaves Lansdown, as there is no capital gains tax to pay on these assets.

This means you won’t pay a penny on purchasing the government bond and the capital gains if you hold it until maturity.

There will be dealing fees if you decide to sell.

Is it worth investing in government gilts?

Gilts or government bonds can provide a regular income and ‘safe haven’ for those worried about volatile equity markets.

Yields have improved for new issues as interest rates have increased.

But gilt yields could become less attractive in the future given that many analysts think the base rate has peaked and the Bank of England could cut the cost of borrowing in the coming months.

It is also worth checking the real return you are getting after inflation.

“The good news for gilt investors is that prices have reset to much more reasonable levels and yields look relatively attractive,” says Laith Khalaf, head of investment analysis at AJ Bell.

“There are still risks out there, notably sticky inflation, the UK election, and the potential for a supply glut coming from a combination of quantitative tightening and new issuance.

“However, the risks and returns on offer look far more balanced than they have since the financial crisis.”

The Bank of England has hiked interest rates to 3% this year, as it attempts to control rampant inflation in the economy. It also looks as if the central bank is going to raise rates again when it meets on 15 December.

In general, higher interest rates mean that borrowing money becomes more expensive, which can discourage borrowing and spending, but they also make it more attractive to save money.

In fact, we’re seeing interest rates on savings accounts return to levels not seen since before the financial crisis as banks fight over our business.

Interest rates on bonds are also on the up, which is good news for investors who’ve been starved of income over the past decade.

Why now could be the time to buy bonds

Interest rates and bond prices have an inverse relationship, meaning that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

This relationship exists because when interest rates increase, new bonds are issued at higher interest rates (commonly referred to as the bond yield), making existing bonds with lower interest rates less valuable. As a result, investors will be willing to pay a lower price for existing bonds with lower interest rates, causing their prices to fall.

Conversely, when interest rates decrease, new bonds are issued at lower interest rates, making existing bonds with higher interest rates more valuable. As a result, investors will be willing to pay a higher price for existing bonds with higher interest rates, causing their prices to rise.

Other factors also influence bond prices. According to Matthew Roche, Associate Investment Director at Killik & Co, “Sentiment is also a major driver of market movement.”

“When investors become more risk averse, they tend to demand higher returns from all assets, including bonds and gilts,” he says.

What are Gilts?

Gilts are bonds issued by the UK government. The term "gilt" refers to the fact that the bonds were originally issued with a gilt edge, meaning that the edges of the bond certificates were finished with a thin layer of gold.

Gilts are considered to be among the safest investments because they are backed by the full faith and credit of the UK government, which is considered to be highly creditworthy.

In September, the mini-budget triggered a huge sell-off of Gilts and yields (the interest rates paid on the bonds) surged.

As Roche points out, yields on 30-year Gilts “rose to a peak of 4.99% from just 1.1% at the beginning of the year.” While the market has since calmed down, yields remain elevated.

Investors can buy a 30-year Gilt today with an interest rate of 3.4%. That’s a lot better than the rate on most savings accounts - especially if you’ve got a large lump sum to invest.

Is it time to buy Gilts?

So, could this be a good time to buy Gilts for income?

“Currently, the bond yields on offer are proving tempting for many investors, particularly in comparison to holding cash, the value of which is still being eroded by inflation despite higher returns,” Roche notes.

With the risk of a recession also growing, bonds could be a “safe bet” for investors seeking income in times of uncertainty.

For many, high quality bonds could represent a good value source of income, especially if stock market investors are hit by recession as we’d expect – in times of financial crisis, many revert to buying bonds as a so-called ‘safe bet’.

“Furthermore, bonds can be held in tax wrappers, such as ISAs and SIPPs,” Roche notes and “Even when held outside tax wrappers, most bonds are not liable for Capital Gains Tax,” he adds.

These tax advantages could be significant for investors, especially when “bonds are purchased below the redemption price paid to the holder on the maturity of the bond.”

It could be time to buy bonds, but there are risks

Still, as is the case with any investment, there are still risks.

“Despite the relative return to calm, in the medium term, there is likely to be continuing volatility linked to market expectations of inflation and interest rate movement, and a related risk premium remains,” Roche notes.

What’s more, there’s a “dizzying array of corporate and government bonds with a range of names, maturities and coupon prices,” so it’s important investors know what they’re buying before getting involved with any particular security.

There are some other benefits of higher bond yields, which are also worth considering. “They will, in turn, boost yields elsewhere, such as annuities. That is potentially good news for savers and retirees, for example,” Roche summarises.

UK government bonds – usually referred to as ‘gilts’ – have been at the heart of some of the biggest financial stories in recent years. Gilt markets almost single-handedly ended Liz Truss’s government in 2022, and they threatened to dislodge Labour chancellor Rachel Reeves from her position early in 2025.

“Gilt” is shorthand for a bond issued by the UK government. In other words, gilts are units of government debt.

“They're essentially loans to the UK government,” said Sarah Coles, head of personal finance at AJ Bell. “You lend them money for a specific number of years, in return for a regular payment known as a coupon.”

This coupon payment is fixed and is often expressed as a percentage of what you paid for the gilt. This is known as the ‘yield’ – exactly the same as the yield on other forms of bond.

“When they mature, the government repays the full face value (known as par value and usually £100) to whoever holds the bond,” Coles added.

Gilts are used by the government to raise money from investors to fill the gap between revenue (taxes) and spending. This makes them central to the financial system, and a key part of how the UK economy functions.

“Generally, gilts are used to borrow to improve infrastructure and fund other longer-term projects that aim to benefit the economy through higher growth and productivity,” said Rob Morgan, chief investment analyst at Charles Stanley.

The average life of a gilt is 14 years, though yields on 10-year gilts are generally tracked as the headline figure when discussing gilt yields.

Because the coupon payment is a fixed amount, the yield (which is a percentage of the price of the bond or gilt) moves in an inverse direction to the price. So in the chart above, which shows price, points where the line is lowest means that the yield is highest, and vice versa.

This matters for the UK economy because the yield on a gilt is effectively the interest that the government pays on its debt. The lower gilt prices go, the more expensive it is for the government to raise money.

How do gilts work?

The government issues bonds via the Debt Management Office (DMO), which is responsible for managing gilt supply and demand and deciding what sort of gilts to issue.

There are various ways of buying gilts. Some investment platforms allow you to buy them directly, but if you aren’t able to do so you could buy an exchange-traded fund (ETF) that tracks the performance of government bonds or gilts.

“[Gilts] can either be bought at issue or in the secondary market,” said Morgan. “Buying at issue means that you get the same ‘yield’ on the bond as the coupon. For instance, if a bond is issued with a 4% coupon you’ll receive £4 of interest for each £100 invested every year until maturity.

“However, if you buy in the secondary market, the gilt may be trading either above or below its ‘par’ value and the return generated could be higher or lower.”

Par value is defined as the face value of the bond – i.e. the amount the borrower is required to repay on the maturity date.

The DMO determines the price of new gilts issued based on market conditions, and yields are one of the key variables that are considered when pricing them.

The question of whether or not gilts are a good investment depends largely on market conditions, as well as your individual circumstances and the role they are likely to play in your portfolio.

Should you buy gilts?

The key advantage of gilts, like other forms of government bond, is that they are a safe investment. The UK government has never defaulted on its debt, and it is hugely unlikely that it ever would.

Rather than default, the government would be more likely to take actions that devalue the value of the pound (in which all gilt coupons are paid), which would diminish the real returns that the gilt holder received over time.

For that reason, two key variables that impact gilts are interest rates and inflation.

You are paid the same amount of money on your gilt regardless of what is happening with inflation: rising costs eat into the real value of this yield. So inflation makes gilts less appealing.

Inflation also tends to lead to higher interest rates, which makes it more likely that investors can find a superior return elsewhere.

“Investors don’t wish to see a below-inflation return on their money, so they want compensation for the risk of inflation being higher than expected – and this ‘term premium’ particularly affects longer term gilt prices,” said Morgan.

For this reason, gilt prices tend to fall, and yields rise, when interest rates go up, and vice versa.

So the ideal time to buy gilts is one where yields are high, but where interest rates and inflation are expected to fall in future.

Yields on ten-year gilts fell to 4.37% – their lowest level since 2024 – on 12 January, and continued to fall further over the following weeks. But when the war in the Middle East started in late February, fears of inflation rose. That raised expectations of higher interest rates, which saw a fall in gilt prices – and, as such, a rise in gilt yields.

Ten-year gilts currently yield around 4.76% (as of 15 April), but they yielded as high as 4.95% in late March.

The latest UK inflation data showed that CPI rose by 3% in the year to February. That means that gilts are currently yielding around 1.78% in real terms (adjusted for the impact of inflation). However, inflation data always comes with a lag – the next UK inflation release date is 22 April, and this will cover March data, which is likely to come in higher thanks to the impact of the conflict.

What are the tax advantages of gilts?

Another reason to consider investing in gilts is that they are tax-efficient.

“Frozen tax thresholds and the looming cut to the cash ISA allowance mean it’s getting harder to keep your savings interest out of the clutches of the taxman,” said Coles.

Coles believes that now is an opportune time to buy certain gilts.

“Gilts with low coupons, issued during the pandemic and set to mature soon, tend to be priced below their par value,” she said. “At the time of writing, for example, there’s one due to mature in January 2028 with a coupon of just 0.125%, priced at £93.20. On its maturity date you’ll get £100 for every £93.20 you put in. The monthly payment is small, so the lion’s share of the gain is the difference between what you pay for it and what you get back when it matures.”

The coupon is taxed as income – but that is a small part of the return on these gilts.

“The rest is the rise in the value of the gilt between when you buy and when you are repaid, and this is free of capital gains tax. It means most of your gain is tax-free.”

How do gilts affect your finances?

The interest rates on gilts set prices for things like mortgages, financial derivatives and can dictate government budgets. They are essentially the foundations of the country’s financial system.

When gilt yields increase, the government pays more interest on its debt. This eats into its budget, meaning less money available for tax cuts or public spending, assuming everything else remains constant.

The UK has around £2.9 trillion of gilts outstanding. While many of these have fixed interest rates over several decades, it’s easy to see how even a small increase in gilt yields can have a huge impact on the country’s financial position.

They are also a significant driver of borrowing costs. For instance, in late 2024 and early 2025, some mortgage lenders increased their rates as gilt yields rose, even though interest rates had been trending downwards.

However, higher gilt yields tend to be good news for annuities.

“The higher the gilt yield the bigger the potential regular retirement income,” said Morgan. “If you have been contemplating buying an annuity with your personal pension pot, it might be an opportune time to take a fresh look at available rates.”

Twenty-one years ago, John Ralfe, then in charge of the £2.3bn Boots pension scheme, took the momentous decision to sell all the fund’s £1bn of equities and invest solely in UK government bonds.

The advantages, he later explained, were that in doing so, he matched the assets of the fully funded defined-benefit scheme to its liabilities, reducing the risk for Boots’ management and shareholders of a future deficit that the company would have to make up. It also reduced the risk for the 72,000 members, lowered investment costs by 97% and, by selling early in the bear market, avoided large equity losses.

Liability-driven investment (LDI) was born and other companies rushed to follow suit, especially those that were fully funded and closed to new employees. New staff were instead offered defined-contribution schemes in which they, not the company, took the investment risk. Companies found an added attraction in that having matched assets to liabilities, they could offload responsibility for the scheme entirely to asset managers such as Legal & General. They earned well from selling LDI.

Gearing up with derivatives

Sceptics noted that without knowing how long the members would live, matching assets to liabilities was an actuarial estimate, not a certainty. More importantly, there weren’t enough long-dated gilts to match the liabilities, so it was just assumed that the proceeds from maturing gilts could be reinvested at the same yield. If yields fell, as they did until 2021, a gap between assets and liabilities would open up and the scheme could become underfunded.

Nevertheless, so popular did LDI become that sponsors extended it to underfunded schemes. The cunning plan (in the Blackadder sense of the phrase) was to invest not in physical gilts but in “swaps” – derivative contracts giving artificial exposure to the gilt market through financial counter-parties such as investment banks. The advantage of this was that even with the required collateral, much less capital needed to be invested, thereby freeing capital to be invested in other assets in an attempt to catch up on the shortfall.

In effect, this meant leverage (ie, borrowing) as the gross exposure to investments was higher (potentially a multiple of) than the asset base. This was fine so long as gilt yields fell and the swaps generated profits, so the success of the model led to it expanding to cover £1.5trn of assets. The switch into LDI is likely to have driven gilt yields to unsustainable lows (0.68% for ten years at the end of 2021) and the selling of UK equities may have depressed valuations.

LDI funds took on more risk than they thought

Simon Wolfson, CEO of Next, not only refused to switch the Next scheme to LDI but wrote to the Bank of England in 2017 that LDI strategies “always looked like a time bomb waiting to go off”. The Bank of England cannot say it wasn’t warned.

Wolfson’s view that LDI funds “are actually taking a lot more risk than they thought they were” has been borne out as gilt yields have risen. The ten-year gilt yield reached 2% in May, 3% in early September and broke 4% as Kwasi Kwarteng announced his poorly-timed mini-budget. It peaked at 4.5%.

The crash in bond markets was a global phenomenon but was exacerbated in the UK not by the mini-budget but by an avalanche of selling by LDI schemes. As gilt yields jumped and the losses on their swap contracts mounted, they were forced to sell what physical gilts they had in order to provide more collateral, and the sell-off turned into a rout.

The Bank of England stepped in with a pledge to restart quantitative easing and buy up to £65bn of gilts to stabilise the market. Ten-year yields have since fallen back below 4%. But the crisis is far from over.

Gilt yields won't return to huge overvaluation

Firstly, the liquidity provided by the Bank of England increases the money supply and will filter through into higher inflation and hence higher gilt yields.

Secondly, the LDI schemes in trouble may have been able to put up collateral and hence avoid insolvency, but the losses remain. It is inconceivable that gilt yields will return to 2% let alone 1%, and even 3% is an optimistic target, requiring inflation to return sustainably to 2%. Bond markets in general and gilt yields in particular are extremely unlikely to ever return to massive overvaluation.

So what can the managers of all those schemes that are under water do? They have a series of unpalatable choices. They can admit that the LDI scheme has failed and go cap in hand to the government for a bailout. They can seek to reduce the benefits to members for which they are contractually liable. They can seek to pass the scheme on to the already overstretched Pension Protection Fund. Or they can seek to make up the shortfall by switching the fund to invest in supposedly higher-risk, higher-return assets such as equities.

As architects of yet another mis-selling scandal, they and their companies can expect no mercy from the media, the regulators, the government, public opinion or, perhaps, the courts. As one shrewd observer points out, “all the mis-selling scandals have come about from those who claim to be reducing risk actually doing the opposite”.

Following the Truss-Kwarteng mini-Budget of 23 September, which was widely deemed fiscally incontinent, the market for UK government bonds (gilts) took fright. Demand for long-dated gilts fell sharply and rapidly, meaning their price slumped and gilt yields (which move inversely to prices) soared.

The consequences for the mortgage market were severe: fixed rate mortgages soared and some lenders withdrew from the market altogether in order to reprice. The political consequences have been turbulent, with the weeks-old Truss government looking painfully unstable.

But what has received less attention – in the melee of recriminations, infighting and policy U-turns – is the role of one particular investment strategy, liability-driven investment (LDI), in forcing the Bank of England to step in and stabilise the gilt markets by buying UK debt.

What is liability-driven investment (LDI)?

LDI is a risk-management strategy used by pension funds, in particular “defined-benefit” funds (final-salary schemes or similar). Obviously, all pension funds have to manage their assets, whether bonds or stocks or other holdings, to ensure that they can always meet future liabilities, namely the monthly payouts to pensioners.

LDI is an increasingly popular investment strategy that uses derivatives to help pension funds match assets and liabilities, in order to minimise the risk of an unforeseen shortfall. In effect, the derivatives (such as interest-rate swaps and other contracts) are intended to hedge the movements in liabilities caused by changes in inflation and interest rates.

Is LDI a bit dodgy?

It’s not some outré tactic, no. Typically, big-name financial institutions including BlackRock, Legal & General and Schroders manage LDI strategies on behalf of pension clients. In addition, there are specialist firms, like Cardano and Insight Investments.

According to the Investment Association, the amount of pension-fund liabilities hedged by LDI strategies was worth about £400bn in 2011, but had quadrupled to £1.6trn by 2021. Even so, there have been warnings of the risks if the era of ultra-low rates should end abruptly.

So what went wrong?

The way LDI works is that to arrange coverage, funds put up collateral – and if yields rise, they have to top up that collateral because the underlying asset, the gilt, is worth less. Normally, funds can easily meet this margin call: they have liquid assets and cash, and usually have days or weeks to make the payments.

What went wrong was that “yields rose so sharply that managers had to come up with the cash in a number of hours”, says Huw Jones on Reuters. Many funds didn’t have enough spare cash, so to meet the calls they “went to their next most liquid assets: gilts, with funds typically holding a lot of the longer-term, inflation-linked variety”.

But this is where the so-called “doom loop” comes in. Because so many funds were simultaneously selling gilts to meet payment demands, yields were pushed higher. And that in turn increased the collateral payments they had to make. And so on, through days of wild rumours about the scale of liabilities, and fears of contagion to other asset classes – until the Bank of England stepped in to stop the cycle.

How did it do that?

By promising to spend up to £5bn every day until 14 October – that’s 13 business days and a potential outlay of £65bn – on buying UK long-dated gilts, if needed, to stabilise the market by keeping yields down. So the bank has restarted its quantitative easing (QE) programme, whereby it buys bonds with printed money.

That headline figure, and the complexities involved, led to the widespread misapprehension of a £65bn state bailout of pension funds. In fact, up to Tuesday of this week, the central bank had so far needed to shell out less than £4bn on its temporary gilt purchase programme.

That doesn’t mean all worries are over. Gilt yields did fall sharply again in the wake of the Bank’s commitment, but they were rising again this week. As of now, there’s no knowing what the final bill will be, nor what will happen in the market once the purchasing period ends.

What can we learn from this?

Even if this bailout ends up costing the Bank of England nothing – as it sells back those long-dated gilts in an orderly manner – it has exposed the manner in which the defined-benefit sector gains from an implicit taxpayer guarantee denied to those who don’t enjoy such pensions.

After the financial crisis, banks paid for their implicit taxpayer guarantee by being hit with an extra tax, says Patrick Hosking in The Times. “There may be a case for defined benefit schemes... to be treated the same way”.

More broadly, the LDI blow-up may be a “harbinger of much bigger problems... in the way the government funds its ever-growing borrowing needs”, said Jeremy Warner in The Telegraph.

What are these problems?

UK pension funds are by far the biggest buyers of UK government debt; £1.5trn of the pension industry’s £2.5trn of assets is held in the form of high-grade bonds – mostly UK gilts. That’s not a good thing: over-investment in bonds that finance current government spending – rather than equities that drive business expansion – is ultimately a “curse on growth and productivity-enhancing investment”, says Warner.

Defined-benefit schemes are now in long-term run-off – and will “eventually become net sellers of gilts rather than net buyers”, which raises its own challenges. Unless the government offers much higher returns, it is unclear why the “next generation of ‘defined contribution’ pension provision would want to [invest] in government debt in quite the same way”. All this is “one more reason... for worrying about [our] irremovable budget deficit”.

The most interesting part of any crisis isn’t the blow-up that you expected – it’s the one you didn’t see coming. The latest development in Britain’s plan to turn itself into an especially chaotic emerging market is that the Bank of England has been forced to intervene in the bond market to prevent the sell-off in long bonds from creating a disaster for pension funds.

Yields on 30-year gilts soared from 3.5% last week to 5% this week, as markets digested the likelihood of more bonds being issued, the prospect of higher interest rates and the way that UK economic policy was looking a bit Marxiste, tendance Groucho.

This is a gigantic move in bond terms, to put it mildly, and one that caused no small amount of grief for defined benefit (DB) pensions.

How rising bond yields can hurt pension funds

This sounds counterintuitive, since higher yields make the present value of pension-fund liabilities lower. In simple terms, they’d need fewer assets now to cover the payments they have pledged to make in future, because bonds – DB pension funds are big investors in bonds, even at the terrible yields we’ve seen for over a decade – now have higher yields and thus will bring higher returns.

However, DB pension funds also use interest-rate derivatives to hedge their sensitivity to changes in rates and better match their liabilities and their assets. Their derivative positions were backed by collateral – eg, long bonds. The massive increase in interest-rate expectations combined with the drop in the value of bonds (as yields go up, bond prices go down) created huge margin calls for these funds and obliged them to post more collateral against their derivative positions.

This didn’t mean they were bust – these positions were intended to hedge liabilities and so should eventually net out – but they had an immediate need for liquidity that was very hard to meet. This may have forced some of them to liquidate positions, worsening the sell-off in long bonds and driving yields higher, creating a feedback loop. Hence why the central bank had to intervene urgently.

What can investors learn?

Very few investors had this on their crisis bingo card (I didn’t, and I worked in pensions two decades ago… hedging wasn’t so big back then). The direct implication for anybody not running a pension fund is limited, but the wider lesson in the unexpected effects of higher interest rates is not.

For example, many investors favour value stocks in an environment of higher inflation and interest rates, for reasons that make perfect sense. But today, many seemingly cheap stocks carry high debts or have weak cash flow. How will they cope when they have to refinance debt at higher yields?

That’s why value investors should still look for solid businesses at this stage of the cycle. The time to buy cheap junk will be after the defaults kick in.

The annual conclave of central bankers at Jackson Hole, Wyoming, is usually only of interest to the nerdiest of market watchers and economists who relish the micro-analysis of the carefully scripted wording of speeches and press releases. But this year was different.

Having raised interest rates this year by 2.25% to a target range of 2.25%-2.5%, the Federal Reserve, America’s central bank, had been expected to “pivot” to a more dovish stance. This might mean that the 0.5% increase in September would be the last, or that the increase would be 0.25%, or that there would be no increase at all.

Instead, Jerome Powell, chair of the Federal Reserve, reiterated the need to bring inflation down by pushing up interest rates whether it caused economic pain to households and businesses or not.

Why the Fed has changed its mind on interest rates

What caused this apparent change of mind?

Not the rate of inflation, which fell from 9.1% in June to 8.5% in July while the core underlying rate fell to 5.9%. Inflation is expected to have fallen further in August and economic indicators point to a further fall in the coming months.

Instead, Powell appears to have reacted to the bond market. The yield on ten-year US Treasury bonds rose from 1.5% at the start of the year to a peak of 3.5% in mid June before falling to 2.6% at the end of July. Since then, it has risen to 3.1%, indicating that while bond yields may accept the current downward trend of inflation, they are not convinced that it will fall back to 2% and stay there.

The gap between inflation-protected and conventional bonds, regarded as a good indicator of inflation expectations over the next ten years, rose from 2.3% to 2.6% so the credibility of the Fed was at stake. The Federal Reserve, it now seems, is committed to a monetary policy that will satisfy the bond market.

The “bond vigilantes”, a term invented by economist and market analyst Ed Yardeni in the 1980s to describe a world in which bond investors drive monetary policy, are back.

It is notable that the 24% fall in the S&P 500 index between the start of the year and mid June, a period in which corporate earnings continued to rise at a brisk pace, coincided almost exactly with the rise in bond yields. So did the 17% rally to mid August, and so did the subsequent 8% fall.

Stockmarket investors are not particularly concerned about the effect any recession would have on corporate earnings because they know that corporate earnings will recover with the economy. They are much more concerned with the risk of higher bond yields, which result in lower interest rates.

If bond investors are happy, stockmarket investors are happy

This goes against conventional wisdom which claims that recessions are “bad” for stockmarkets, so markets will be undermined by higher rates. Investors want central banks to do whatever it takes to knock inflation back, regardless of the short term economic consequences. If bond investors are happy, stockmarket investors will be happy too, and the yield on ten-year US Treasuries is the best indicator of investor confidence.

Consumers and businesses do not like paying higher interest rates on their borrowings, but they like inflation even less. They do not want a recession with its attendant risk of unemployment and falling living standards but will probably accept some short term sacrifice if the result is lower inflation and interest rates, combined with a return to growth in the longer term. We are all inflation vigilantes now.

The reason US inflation is falling – and hence the economy is in good shape – is down to energy. Fracking has made the US self-sufficient in oil and gas, in addition to which the US is bordered by two hydrocarbon-rich friendly countries. Europe, in contrast, trusted its future energy needs to Russia, succumbing to anti-nuclear superstition and a Russian-backed campaign against fracking. There are few signs of policy change.

Britain lies somewhere in the middle with plenty of hydrocarbon reserves, but an aversion to exploiting them.

The UK seems intent on making the problem worse. The Bank of England has proved slow to raise interest rates with the result that sterling fell 5% in August alone. This promises to exacerbate inflation and worsen the outlook for the UK economy.

The government has the fiscal headroom to alleviate the downturn, but all the media and popular pressure is for short-term fixes which will make the problems worse.

The imperative is to reduce demand for hydrocarbons and increase supply, not to finance short-term hand-outs through borrowing and production taxes. We will soon see whether the new government will rise to the challenge.

The world follows where the US leads

Ed Yardeni notes that falls in US GDP in the first two quarters match the definition of recession but he expects the data to be revised upwards, helped by strong employment. He doesn’t “expect any downturn over the rest of the year and/or next will be severe enough to qualify as an official recession” but instead sees the continuation of a “rolling recession” passing through different sectors and regions.

As a result, he expects “S&P 500 earnings growth of -5.4% and -3.8% year-on-year in quarters three and four” which still means growth of 3.1% for the year as a whole and 9.3% next year.

That puts the S&P 500 on 18.4 times this year’s earnings and 16.9 times next. Whether that is cheap or expensive depends very much on the Federal Reserve dancing to the tune of the bond vigilantes. If it does so, US Treasuries may even be reasonable value.

The US accounts for 62% of the global stockmarket, while Japan, where inflation is just 2.5%, is also in good shape. The countries facing serious economic challenges, including the UK, the EU and China, make up less than 20% of the index. As the US goes, so will world markets.

SEE ALSO:

The companies that could benefit from Russia’s gas war

Is the rise in bond yields and corresponding fall in bond prices bad news or good news? It depends on your perspective.

In the last year, yields on ten-year gilts (UK government debt), having been barely positive a year earlier, rose from 0.5% to a mid-June peak above 2.5%, though they have since slipped back to 2.1%.

Yields on 30-year gilts have risen from below 1% to over 2.5%, resulting in a capital loss to holders of these bonds of 20%.

Given that these yields remain below those of the comparable US Treasuries (US government debt) against the historic norm, it is likely that they will continue to rise and that the multi-century lows of a year or two ago were an anomaly.

Who owns all our debt?

This is clearly bad news for holders of gilts – but most private individuals sold out long ago. Maybe some pension funds still held some, though they would be wise to keep that quiet. Insurance companies, who are heavily restricted by “solvency” rules, are significant holders of gilts, but mostly short-dated ones with little capital risk and a modest yield premium over cash deposits.

The big holders, according to the Financial Times, are now “overseas” – central banks on behalf of their governments as part of the deployment of their foreign exchange reserves – and the Bank of England, which has bought back £875bn of gilts, 45% of the total in issue.

This means that the UK government’s debt-to-GDP ratio, nearly 95% gross, is only 52% net, though that would rise if the Bank of England has to sell some or all of those gilts to rein in excess liquidity. Excess liquidity would be the result of a surge in bank lending, which has been severely curtailed since the financial crisis, but that looks unlikely to happen.

The other big loser from higher gilt yields is the government and, through them, the taxpayer who, as existing gilts mature and are refinanced, will have to pay a higher interest rate. Debt service costs, excluding those on gilts owned by the Bank of England, currently sit at £40bn per year. That’s 1.7% of national income and 4.3% of public spending. This is set to rise inexorably.

On the other hand, ultra-low borrowing costs have encouraged the government to spend vast amounts of money on vanity projects such as HS2, though, fortunately, they have not (yet?) reached the lunacy of France’s nationalisation of EDF. Curtailment of government extravagance would be positive for taxpayers and the economy, even if higher rates do raise the hurdle for private sector infrastructure spending.

Why rising gilt yields can be good news for pensioners

Other potential winners are risk-averse pensioners, who are at last seeing annuity rates rise. This means that the lump sum in their pension pots will buy a higher lifetime income – one which is completely safe from market and economic volatility – than it did a year ago. Annuity rates are estimated to have risen 23% since their low in early 2021.

The other big winners are members and providers of fully-funded defined benefit pension schemes. Notable among these is the Universities Superannuation Scheme, a £90bn fund covering over 400,000 people employed in higher education.

In recent years, the fund has been reporting mounting deficits, reaching £14.1bn at the March 2020 valuation. Assets were calculated by the actuaries to be only 83% of commitments, though calculations depend on a number of assumptions. These include: longevity, future contributions, investment returns, future pension entitlements and – crucially – discount rates. The latter, the rate at which future liabilities are discounted to the current day, are based on gilt yields.

A sensible critic might argue that there are so many uncertain assumptions as to make the conclusions highly unreliable, but the trustees have to follow the “professional” advice of the actuaries and the employers have to implement the recommendations, subject to any push-back they can exert.

The employees had seen a remorseless squeeze on their entitlements and a sustained rise in their contributions. The rise in employer contributions was passed onto them (higher education institutions having little spare room in their finances) in lower pay increases. The result was understandable fury and a series of trade union-supported walk-outs across the country.

A further squeeze on benefits was implemented at the start of April. But soon after, the Universities Superannuation Scheme announced that its 31 March valuation had shown that the deficit had fallen to just £1.6bn, making the scheme 98% funded. Moreover, this was primarily due to an increase in assets rather than to a higher discount rate, the result of higher gilt yields, reducing liabilities.

Since gilt yields rose further in the second quarter and, notwithstanding the recent decline, are likely to rise further still, the position of the Universities Superannuation Scheme and other defined benefit schemes is likely to continue to improve.

In the short term, weak markets, notably equities, will have reduced assets but these losses will be soon recovered as markets resume their long-term relentless move upwards.

Staff should now be able to look forward to a reinstatement of benefits and/or lower contributions while the financial squeeze on higher education will diminish.

The losers are the actuaries, whose reputation is tarnished, and the trustees who loyally followed them. As one bemused finance director said, “the pensions system is supposed to reduce the volatility of everyone’s exposure to the vagaries of markets but it’s done precisely the opposite.”

There is one final loser from the rise in bond yields – advocates of “modern monetary theory” (MMT) who claim that government spending should not be constrained by rising debt as central banks can just create money to finance it. This theory attracted a following among progressive economists and politicians but has now been buried.

The recent rally in bond markets helps limit the scale of necessary interest rate rises and underpins equity markets. But in the longer term, a return to yields which are moderately higher than much lower inflation would mark a return to sanity.

The last few weeks have been a “bloodbath” for bond investors, says Rachel Rickard Straus in The Mail on Sunday. Bonds are supposed to offer “a regular, safer income and a ballast against more volatile shares”. It hasn’t worked out that way. Global bond prices, as measured by the Bloomberg Global Aggregate index, are down 10% since the start of the year. Yields, which move inversely to prices, have spiked. “UK investors ditched £2.5bn of bond funds in February alone – the biggest outflow since the start of the pandemic”.

As with so much else, the culprit is rising interest rates. “Bond issuers have to offer something even more enticing to investors than what they could get simply by putting their money in a low-risk, interest-paying account”. Higher yields mean investors who buy into bonds now are getting a better deal, but those who are already holding bonds suffer capital losses. The yield on the US ten-year Treasury bond has risen by more than one percentage point since the start of 2022 to about 2.75%. At the start of the pandemic it traded as low as 0.53%.

A short, sharp cycle

The sell-off isn’t done yet, says Thomas Mathews of Capital Economics. Interest rate rises could push up the ten-year Treasury yield to 3.25% by the end of 2022. Still, “this hiking cycle looks increasingly likely to be a sharp but short one”. Once central banks “stamp out inflation” they may need to reduce rates to support a slowing economy.

“Bond market pessimism has become so extreme that a rally is a distinct possibility”, says Mark Hulbert for MarketWatch. A few “brave advisers” are asking whether things have gone too far. Their case rests on the argument that central banks may ultimately raise rates less quickly than anticipated. Inflation may have already peaked or be about to do so, and the economy could be heading for recession, both of which would give bonds a boost.

Rising real yields

Rising nominal yields don’t tell the whole story, says John Authers on Bloomberg. With inflation roaring, the “real yield” (ie, yields adjusted for inflation) that investors can expect from bonds has stayed low for most of the past year. Real yields are a better measure of whether financial conditions are actually tighter or not. As measured by ten-year Treasury inflation-protected securities (Tips), real yields in the US had been below zero since March 2020. Yet even that is changing. Last week the ten-year Tips yield briefly crept into positive territory, before falling back again.

Negative real yields have driven much of the risk-taking in markets over the past two years, says Lisa Beilfuss for Barron’s. “A flip in real yields from negative to positive should spur a reversal in some of that yield hunting.” But that may be optimistic, says Jim Reid of Deutsche Bank. On current inflation, ten-year Treasuries are yielding -5.6%. The Tips yield is ticking higher only because investors expect inflation to fall in the next few years. “I’m still not convinced inflation falls anywhere near enough over the next couple of years for real yields to get anywhere near positive… If I’m wrong… run for the hills given the global debt pile.”

• SEE ALSO: Why food and fuel subsidies will push up debt

Before we get started today, a reminder – if you want a good excuse to be in Edinburgh on Saturday 30 April, Merryn and I will be interviewing one of the smartest people in finance, Russell Napier, to celebrate the opening of the new premises of his Library of Mistakes.

The event is completely free, but tickets are limited, and more than half of them have gone already, so be quick and reserve your spot now. I’m looking forward to it and it’d be nice to see you there.

It appears that the bond bubble has well and truly popped.

Bond investors – accustomed to steady, perhaps even “rather good by historic standards” annual gains – have experienced some of their biggest losses on record over the last year or so.

So what happens now?

Bond prices are collapsing

US long-dated Treasury prices have fallen roughly by a third since the middle of 2020, notes Louis-Vincent Gave of Gavekal. That means that “Treasuries have now taken out more than five years’ worth of gains and accumulated income, with the asset’s long-dated index back at its July 2016 level”.

Ouch. Those are the sorts of losses that might make even an equity investor wince. For a bond investor – used to the idea that these are risk-free assets, the sensible ballast weighting the flightier, riskier parts of your portfolio – it must feel like the world is falling in.

So what’s going on? As a quick reminder for those of you who glaze over as soon as the subject of bonds comes up, most government bonds pay a fixed income. So when bond prices fall, yields rise (just like the relationship between dividends and share prices).

So another way to put all this is that US long-term interest rates hit a bottom in mid-2020 and have since risen sharply.

There are good reasons for this. Ordinary bonds (as in, ones that pay a fixed income) are allergic to inflation. Why’s that? Well, if an IOU promises to pay you £5 a year, every year, with no credit risk, until it matures, how much are you willing to pay for it?

The answer is: it depends. But if you expect inflation to be high and rising in the future, you’re going to pay less than if you expect inflation to fall or even turn negative.

In the first scenario, your £5-a-year payout is losing value every year at an accelerating rate. In the second scenario, your £5 is losing value at a slower rate and if inflation turns negative, it might even become more valuable.

Put very simply, we’ve gone from an environment where investors largely believed that the first scenario was more likely than the second, to a scenario in which investors are starting to believe that the second is more likely.

So it makes sense that long-term bonds (which are more sensitive to all this stuff than short-term ones, because their value is more dependent on payouts further into the future) have dropped in value.

Also, note that it’s not just the long bond – bond prices are falling and yields are rising across the board. High-rate US corporate debt for example, notes Lisa Abramowicz on Bloomberg, now yields more than 4%, not far off its highest level since 2011.

And of course, the mountain of negative-yielding debt that became such a glaring indicator of the downright weirdness of the post-financial crisis era, has now thawed away close to nothingness, sitting at around $2.7trn, the lowest figure since 2015.

There’s more to it than simply inflation rising, it’s also about how central banks react to inflation. We last saw moves in the bond market like this in the period between late 2017 and late 2018.

That’s when the Federal Reserve, America’s central bank, started raising interest rates in the hope of getting back to something approaching “normal” again. That was aborted after China’s growth panic stopped the Fed in its tracks and we then saw long-term yields drop over the course of 2019.

Then of course we had the corona panic during which the world’s central banks flooded the place with liquidity and thus pushed bond prices higher and yields lower.

Bond prices are now largely around about where they were at the most recent bottom in late 2018. The reason the pain has been much more dramatic this time round is because they fell from a higher peak, and the decline has been more rapid than during 2018.

What might cause a rebound in bonds?

What turned bonds around last time is the Fed changing its mind about interest rate rises. Could the same thing happen again this time?

It’s worth considering, given the pleasing symmetry in the charts, if nothing else. It’s exactly the sort of area you might expect to see a rebound if you place stock in such things.

More than that, you have to think that central banks must be starting to get nervous. We had the yield curve recently signalling a recession. We have interest rates on government debt shooting up at a time when there’s an awful lot of government debt out there.

And there are all sorts of concerns about bits of the financial plumbing. The commodities sector is having many tribulations with the rising costs of insuring against price moves; the Japanese yen is cratering. These are all distress signals.

Moreover, Bank of America’s latest global fund manager survey also showed that fund managers are exceptionally gloomy about the outlook, more so than they were even after the financial crisis of 2008, which is striking.

They are also extremely worried about market fragility – in other words, they think something is set to break. And they hate bonds.

That all signals to a contrarian investor that it might be time for the tension to break and something to change. The most obvious thing would be that we get some sort of mild relief on the US inflation front (all you really need is the April figure to come in a bit less astronomical than forecast) and the Fed can nod to being a bit less hawkish and you’ll get a relief rally.

Ironically, the other thing, which Gave points out, that might give a short-term rebound to US Treasuries would be a victory for Marine Le Pen in the upcoming French election, which could see a “safe haven” rush.

Either way, I don’t think it would represent a long-term change – I suspect that this time the bond bubble really has burst for real.

On that front, I’d just reiterate that you should make sure you own some gold, and also make sure you hold some cash for the inevitable panics that will no doubt be part of the return to “normal”.

I’d just add that this is all the sort of stuff that we may well be chatting to Russell about on 30 April, so do come along if you get the chance.

Global bond markets have had a terrible year so far.

To take one measure cited by FT Alphaville, the Bloomberg Global Aggregate bond market index has fallen by more than 11% since its peak in January 2021, which is “the biggest setback since at least 1990”.

Yes, I realise that for those of you who focus on equities, that doesn’t sound like a big deal. Sometimes equities can lose that in a week, and you just have to suck it up.

But believe us, this is a big deal for bonds.

Bonds are struggling because investors believe that inflation is real

To take another measure of how bonds have struggled in recent years, Louis-Vincent Gave of Gavekal points out that 30-year US Treasuries have shed 30% since their 2020 highs.

Oh and the recently-issued Austrian 100-year bond has halved in value from its 2020 high point.

Those are massive falls. As Gave puts it, “most major government bond markets outside China have delivered the kind of price behaviour last seen in 1994.”

That year saw an incident known as the “bond market massacre”, which was a formative event in creating the “bailouts at any cost” philosophy of Mr Alan Greenspan, the architect of our present financial tribulations.

Anyway, this is having some interesting side-effects. As Ft Alphaville points out, negative-yielding bonds are almost a thing of the past now. In 2020, the volume of bonds that charged you to own them peaked at almost $18trn.

Now, there’s just $2.9trn of these collectors’ items out there (quick! – someone turn them into NFTs, you’ll be able to lose twice the amount of money in half the time).

Half of government bonds traded on negative yields in August 2019, according to Matthew Hornbach of Morgan Stanley. Now it’s just 7%.

That’s all very interesting, but what does it mean?

It’s really just an extremely vivid portrayal of how the environment has changed. The “long duration/jam tomorrow” bubble has well and truly burst. Deflation is no longer the bogeyman for investors.

The big shift now is that they’re starting to become properly unnerved by inflation. And that’s going to cause some tricky balancing acts for governments and central banks.

Why the Japanese yen is confusing investors

Perhaps the clearest demonstration of this lies in another intriguing shift in financial markets today – that is the behaviour of the Japanese yen.

Usually, when things are going wrong in markets, the yen gets stronger. It’s historically been viewed as a “safe haven” currency.

This used to baffle investors – Japan has always had ugly-looking public finances, so the view of the yen as somewhere to take shelter always seemed odd to many.

Now, though, investors are surprised to see that rather than strengthen, the yen is weakening fast.

For all the confusion, there’s a clear reason for this: every other major central bank is either raising interest rates or talking about it, but the Bank of Japan has no plans to budge.

Usually, if one central bank is running looser monetary policy relative to another central bank (as the Bank of Japan is relative to the US Federal Reserve, for example), the currency with the profligate central bank will weaken versus the one with a slightly more vigilant guardian of its currency.

Hence the slide in the yen versus the US dollar.

However, there’s another wrinkle here. The Japanese central bank operates a policy of yield curve control. This involves controlling long-term interest rates by setting a target yield for specific bonds, and promising to print whatever money is necessary to keep the yield at that level.

The Bank of Japan introduced this policy in 2016, when it said it would target a 0% rate on the ten-year government bond yield. The irony is that when this target was set, the bank’s goal was arguably to keep the ten-year yield from turning negative (bad news for bank profits), rather than keeping it from rising.

However, now bond yields around the world are going up, and Japanese government bonds are no exception. That has led to the Bank of Japan stepping in today to enforce a cap on yields of 0.25%.

The thing is, if you print money to cap yields, you batter your currency – and that’s exactly what’s happened.

We’re talking about the return of the “yen carry trade”, whereby cheap money makes its way out of Japan (and thus out of yen) and into higher-yielding assets elsewhere. This was all the rage in the days before the financial crisis; it was one of the things driving asset prices higher.

It was also one of the things that exacerbated the savagery of the collapse, because the risk is that everyone has to liquidate their trades at once, which then sends the yen much higher again, and destroys any profits made on the trade.

What might happen next? The Bank of Japan seems determined to defend the yield peg. Inflation is picking up in Japan but it’s nowhere near levels in other parts of the world.

But this is a tricky balancing act. How far do you let the yen go before the collapsing currency becomes a problem? And when you decide the yen has fallen too far, how far do you let Japanese bond yields rise before you step in there too?

I suspect this is just a preview of the wrestling match that central banks in the US, the UK (and the eurozone) are about to face too.

The choice between interest rates and currency is likely to require some sort of global co-ordination – one way to avoid a given currency collapsing is for everyone to weaken at roughly the same pace.

I suspect this world – one where all currencies come under pressure – is good in the long run for gold. But we’ll see.

Between war and inflation, markets have a lot to worry about. So fretting over an arcane-sounding bond market phenomenon may not be top of your priority list. But if history is any judge, it should be. We’re talking about the “inverted yield curve”. We explain exactly what a yield curve is here, but, put simply, when a yield curve inverts, it means that the interest rate on long-term government bonds is lower than that on short-term ones. That’s a sign that the market thinks interest rates will have to fall in the future, which implies slower growth, or even a recession.

The good news is that the most significant bit of the yield curve, the gap between the two-year US Treasury bond and the ten-year, is yet to invert. As of Monday, the ten-year yields around 2.3% while the two-year yields 2.1%. The bad news is that bond investors are betting that within three months, the two-year yield will be above the ten. And in the last 40 years, every time that’s happened, a recession has followed within 24 months.

It’s probably not different this time

No indicator is perfect and we only have a limited data set to draw on (recessions don’t happen that often). So it could be different this time. For example, Morgan Stanley strategists believe the curve will indeed invert, but that this time it won’t signal a recession, because of distortions related to quantitative easing. However, as Eoin Treacy notes on FullerTreacyMoney, “rationalisations for why this time is different crop up whenever the yield curve approaches inversion”. But what could prevent the inversion?

Inversion is typically driven by markets fearing that Fed will raise interest rates too aggressively for the economy to handle. That’s exactly what’s happening now. So if anything prevents the inversion, it’s likely to be the Fed either getting cold feet, or clear evidence that the economy is genuinely running hot enough to handle rate hikes.

Perhaps a more important question for investors is: if we do face a recession, is there anything you should do?

Recessions are undeniably bad news for stockmarkets. Robert Armstrong, writing in the Financial Times, cites Bank of America’s Stephen Suttmeier, who reckons that “during the average recession, the S&P 500 drops by a third over 13 months”. Yet history also suggests that markets typically don’t hit a top until the inversion has happened, which implies the US market could still have a way to rise before it goes down. So despite the indicator’s strong track record, trying to use it to time the market is futile. A better bet is to make sure you have cash to take advantage of any opportunities that arise; and focus on buying at low valuations, rather than predicting the future.

Bond markets think central banks are about to get tough. The yield on the benchmark ten-year US Treasury bond has risen above 2% for the first time since 2019 following this week’s data showing that US inflation hit 7% in December. Investors are betting that the Federal Reserve will be forced to raise interest rates seven times this year to get price rises under control.

Typically, investors demand higher yields for holding bonds that mature further in the future: the US two-year Treasury pays less than 1.6%, compared with 2% for the ten-year, say Davide Barbuscia and David Randall on Reuters. However, “yields of short-term US government debt have been rising fast this year, reflecting expectations of a series of rate hikes” while “longer-dated government bond yields have moved at a slower pace”. Hence the gap between the yield on short- and long-duration bonds has been falling. This trend – referred to as the yield curve “flattening” – implies that investors think tighter monetary policy will lead to slower growth.

So far, the bond sell-off has been “relatively broad and orderly”, says Marcus Ashworth on Bloomberg. Investors are starting to distinguish between classes of bonds again: riskier bonds have seen their yields rise more than safer government bonds. “Italy’s yield premium to Germany… is at the widest for more than a year.”

Still, last year was the global bond market’s worst since 1999, says Mark Tinker in the Australian Financial Review. The start of 2022 has also been “absolutely terrible”. After years of almost free central bank money and expectations of low inflation, the market is now being forced to reprice. Inflation is soaring and central banks are preparing to sell some of their bond holdings. “The question for long-term investors… has to be ‘why own any bonds at all?’.”

Years of emergency monetary policy – of interest rates near zero and rampant money printing by central banks – have created plenty of notable distortions in the markets.

Perhaps the plain weirdest of these distortions was the phenomenon of the negative bond yield.

The good news is that this aberration is now dwindling away. Nature, as they say, is healing.

The big question now is – can markets cope?

Negative-yielding bonds are vanishing fast

Bonds are a type of IOU. If you lend me money, you’d expect something in return for that – that something would be interest.

The exact amount of interest you want would be based on several factors, but the main ones include: a) how long I borrowed the money for; b) how much you think you can trust me to pay it back; c) the sorts of rates you could get by lending to other people or sticking your money in the bank.

What you probably wouldn’t see as a good – or even valid – deal, is you lending me £100, on the condition that I paid you back £99 at the end of the term.

And yet, that’s the deal that many investors have accepted to with investment-grade bonds (mostly, but not entirely, government bonds) over the last five years or more (you can read more about why anyone would buy a negative-yielding bond here).

Negative-yielding bonds started to become a major phenomenon in around 2014, then spiked (with the Brexit vote, and related – if confused – concerns over the eurozone) in 2016.

Everything started to calm down, particularly as the Federal Reserve, America’s central bank, started raising interest rates in 2018. But then China’s growth scare kicked in, the Fed reversed course and the volume of negative-yielding debt hit a new high in late 2019. Then Covid came along and we got another fresh record high of more than $17trn in late 2020.

But now we’re back to that 2018 low, at around $7.7trn and falling. The most eye-catching evidence is from the German Bund market. As recently as last week, if you’d decided you fancied lending money to the German government over ten years, you’d have had to pay them for the privilege.

Yet today, you’ll get paid more than 0.15% a year. A bargain, I’m sure you’ll agree. Even more strikingly, if you’d bought the five-year bond at the right time this morning, you’d have bagged the princely yield of 0.032%.

In other words, the German government is finally having to pay to borrow money again.

What’s changed? There are the obvious pointers: inflation is rocketing across the globe; no one is terribly happy because living costs are surging, and you can certainly debate what happens next, but at the same time, unemployment is low and most economies are seeing strong growth.

So even those investors who are most fearful of deflationary collapse are perhaps revising their views.

Central banks are getting much more aggressive – but for how long?

But of course, there’s a much more obvious driver of negative interest rates which has gone away. It’s the same thing that drove the spikes in 2016 and the slide in 2018.

When central banks are printing money to buy government debt, it’s a no-lose proposition. You can buy a load, and then flip it to the central bank, and make a guaranteed profit. In other words, you aren’t hanging around to actually pay the negative rate.

This is ending. Yesterday the Bank of England both raised interest rates and stopped its money-printing programme. The Bank’s tone surprised some people (not to mention governor Andrew Bailey’s somewhat baffling plea that people should avoid asking for pay rises, even as he was outlining just how bad the cost-of-living squeeze is about to get – if anything points to a wage-price spiral happening, it’s this sense of official panic).

However, even more surprising for markets was the European Central Bank’s change of tone.

The ECB didn’t actually change interest rates or its money-printing programme, but in the press conference afterwards, Christine Lagarde, the ECB president, made it very clear that the bank is no longer erring on the side of economic caution. In fact, it’s now worried about inflation.

Long story short, before Lagarde spoke, markets had been betting that the ECB would not move interest rates at all (or only once) this year. After she sat down, that expectation had shifted to four interest-rate rises. That’s a big change.

Have inflation prospects changed so much in such a short period of time? Of course not. But now that the Fed is being more punchy on inflation, and now that it’s a headline-grabbing issue, the other central banks can’t ignore it.

The idea that they can do anything about soaring energy prices is facile, but to admit this would be to admit that, in fact, central banks don’t really have the sort of control over what’s laughably described as the economic “machine”, as they’ve been credited with over the last couple of decades or more.

Anyway – why does all of this matter to you as an investor? Well, on the one hand, higher interest rates – assuming they don’t create a recession – should be good news for banking stocks and their profit margins. So that’s your share tip side of things taken care of.

On the other hand, it does raise the question of what happens as all of these countries start finding their interest bills going up. For example, the eurozone crisis feels way back in the mists of time now, but we shouldn’t forget that one key function of ECB money printing has been to keep interest costs down for “periphery” eurozone countries.

I don’t think we’ll see a 2010-style crisis there again. But at some point, investors might start getting edgy about lending to the likes of Italy. It’s probably worth keeping an eye on the spread (the gap) between the yield on German bunds and that on other eurozone nations’ debt.

When push comes to shove, there’s a good chance that central banks are at some point going to have to choose between pretending to tackle inflation and keeping a lid on unsustainable borrowing costs.

That’ll be something to watch.

“The stockmarket seems to... be having its ‘taper tantrum’,” say Jacob Sonenshine and Jack Denton in Barron’s. Last week the US Federal Reserve signalled that it could be ready to start reducing (or “tapering”) the amount of emergency support it gives the US economy before the end of the year. It is currently buying $120bn-worth of US government bonds and mortgage-backed securities (MBS) with printed money every month. A reduction in central-bank stimulus is bad for stock and bond prices, but markets had so far shrugged off the prospect of monetary tightening.

Yet on Tuesday the S&P 500 fell 2%, its worst day since May, as bond yields (which move inversely to prices) rose. The benchmark US 10-year Treasury bond yield has gone above 1.5% for the first time since June. Higher bond yields prompt investors to buy bonds and ditch stocks.

Barring serious economic turmoil, the Fed is now expected to announce tapering in November, says Justin Lahart in The Wall Street Journal. It looks poised gradually to reduce the pace of monthly asset purchases until they hit zero sometime in the middle of 2022. That could open the way for interest-rate rises before the end of next year.

On this side of the Atlantic, the Bank of England is also moving closer to raising interest rates, says Paul Dales of Capital Economics. The Bank left rates unchanged at 0.1% and the quantitative easing (QE) target at £895bn during its September meeting. Yet the minutes noted that the case for some “modest tightening in monetary policy” had “strengthened” since its last meeting. The Bank appears to be more worried that inflation will stay stuck above the 2% target (which necessitates earlier interest-rate hikes) than that the economic recovery is losing steam (which would require policy to stay looser for longer).

The Bank seems to have taken a slightly “hawkish” turn, agree Sanjay Raja and Panos Giannopoulos of Deutsche Bank. Policymakers are just waiting to see what effect the end of furlough has on the job market before acting on inflation. The analysts now expect the bank to raise rates to 0.25% in February 2022, with a further rate hike in November next year to 0.5%. This week the Bank’s governor, Andrew Bailey, indicated that the Bank might even hike rates before the current QE programme finishes at the end of this year.

The Bank of England owns more than a third of UK public debt because of quantitative easing, says Jeremy Warner in The Daily Telegraph. Easy money has saved “the Exchequer billions in debt servicing costs”. Yet growing inflationary pressure could force it to “jack up interest rates”, which will cost the Treasury billions. The health of the public finances is “a matter of growing concern”.

A quick reminder before we get started this morning –don’t miss our webinar on Wednesday 20 October with BlackRock Smaller Companies trust.

I’ll be talking to manager Roland Arnold about his views on the outlook for the UK’s smaller companies against the current turbulent backdrop. Don’t miss it – register free here, and you’ll be able to watch it later even if you can’t tune in on the day.

Markets have been jittery over the past month. We haven’t seen a crash – or anything like a crash – but the relentless rise of the S&P 500, for example, has taken a bit of a knock. It last hit a new high on 6 September, and it’s been drifting lower since.

The best word for asset markets as a whole is probably “unsettled”. So what’s going on?

What’s rattling markets?

The pound has tanked in recent days. Energy prices are rocketing – oil hitting new eight-year highs, natural gas going through the roof. Gold is having a dreary time of it.

Equity markets are mixed – the FTSE 100 likes weak sterling and strong oil, so it’s doing better than most, but both the Nasdaq and the S&P 500 are struggling to regain their momentum, while Japan’s Nikkei is also wobbling around the 30,000 mark.

And then of course, there’s the big boss market of them all – the US Treasury market. US government bonds have been falling in price, which means yields have been going up.

As Dominic noted yesterday, this is not an easy environment for an investor to navigate. But what lies at the heart of this present discombobulation? I want to try to pick it apart a bit today.

Unless you’re a short-term trader, you really don’t need to worry about the odd bit of market quicksand. But it is helpful to wrap your head around the long-term trends so that you can work out if you need to make more significant adjustments to your asset allocation.

The big picture issue is straightforward: investors have grown used to trading in markets which are underpinned by the presence of central bankers who are willing and able to buy government bonds – the foundation assets on which all else rests – at whatever price is on offer.

This has suppressed volatility, and it has helped to keep interest rates low.

The one big risk to this comfy world is, and always has been, the return of inflation. If the outside world is disinflationary or even deflationary, then central banks can print what they like. You’ll create lots of distortions – rampant wealth inequality for one – and what Austrian-School economists would describe as “malinvestment”, but you won’t breach your inflation target. And that matters, because it means you can keep going with the money printing and the volatility suppression.

The problem now is that inflation is returning, and it’s returning fast. It’s already gone beyond the early definitions of “transitory”. Transitory no longer defines a specific time period so much as a specific type of inflation.

As long as soaring costs don’t get passed into the wider economy (mainly via ingrained wage rises), central bankers hope that supply chains will eventually fix themselves and that, in the meantime, they can wait it out.

But it’s clear that they are nervous about all this. The word “transitory” remains, but the more they say it, the greater the sense that they are just whistling past the economic graveyard.

This is why you are seeing central bankers still saying “transitory” even as they’re becoming steadily more hawkish at the edges. And the market doesn’t like that.

Bond yields could spike higher

One of the most obvious reflections of this is the rise in bond yields. The US ten-year bond has gone up from 1.3% to 1.5% in the last two weeks. That doesn’t sound like much, but it’s been quite a fast move, and when you have as much debt to roll over as the US does, every basis point (that is, 0.01%) counts.

This in turn is driving the US dollar higher (which, incidentally, is the more significant reason for the pound’s weakness – there are two sides to every forex trade, remember?)

It’s a very clear response to the fear that the Federal Reserve is going to start cutting back on the amount of quantitative easing (QE) it does (“tapering”).

Mohammed El-Erian, a man who presumably understands his bond markets, given that he was high up at bond fund giant Pimco for a long time, wrote about this in the FT yesterday.

The danger, he says, is that we might see “yields suddenly ‘gapping’ upwards given that we are starting with a combination of very low yields and extremely one-sided market positioning.”

Unfortunately, El-Erian doesn’t really have much to offer (in this piece at least) beyond diagnosing the problem. In effect, markets might have another taper tantrum.

So what would that mean? Central banks – the Fed specifically – will want any transition to go smoothly. This is why Jerome Powell, the Fed chair, has been at pains to emphasise that the taper is entirely separate to interest rate rises. He’s pitching it more as a way to unwind emergency support, rather than as a runway towards higher rates.

You can see why Powell might think this. Ironically enough, past doses of quantitative easing (QE) have in fact pushed bond yields higher, and they’ve fallen as QE has ended. However, I wonder if that environment has now changed. Back then, markets feared deflation. So when QE ended, they acted as though the economy was going to collapse and piled into the perceived safety of Treasuries.

However, if markets are getting worried about inflation – and they seem to be – then the risk is that QE is now suppressing rather than underpinning yields. In other words, the only thing stopping markets from pricing more inflation into the bond markets is the Fed’s presence.

What does it all mean? Well, I still suspect that when push comes to shove, financial repression will be the order of the day. Regardless of what happens with inflation, global bond markets simply cannot be allowed to reprice to more “normal” levels because that would literally bankrupt most nations.

There’s an interesting quote from Powell, speaking at a virtual conference of central bankers yesterday hosted by the European Central Bank. Powell was asked at one point whether the US had “overdone” it with public spending and monetary policy during the covid pandemic.

Here’s how he replied: “I think the historical record is thick with examples of undergoing it, and pretty much in every cycle, we just tend to underestimate the damage and underestimate the need for a response. I think we’ve avoided that this time.”

That’s very telling. I think it demonstrates where the central bank mindset is these days. We might be going through a wobble right now, but when push comes to shove, the instinct will be to step in.

We’ll probably need another market spasm before that. Maybe we’ll get one in October, as is traditional.

Anyway – if you haven’t already subscribed to MoneyWeek magazine, now’s probably a good time to do so.

The dreaded “taper tantrum” has turned out to be a “taper whimper”, says Will Denyer of Gavekal Research. US Federal Reserve chairman Jerome Powell’s speech at the Jackson Hole conference confirmed plans to cut monetary stimulus later this year. You would expect liquidity-addicted investors to be upset by that prospect, but they took the speech “in their stride”.

Taper yes, rate hikes no

The Jackson Hole “jamboree” had been “looming over the market for months”, says Katie Martin in the Financial Times. The event often sees a central banker “say something silly” that upsets traders. Powell chose to play it safe, allaying concerns about overly hasty monetary tightening.

The Fed is currently buying $120bn-worth of US government bonds and mortgage-backed securities (MBS) with printed money every month as part of its emergency response to the pandemic. With the recovery under way it needs to start cutting back (or “tapering”) that support. But it is a treacherous path: in 2013 a similar move by then-chair Ben Bernanke triggered the “taper tantrum”. The resulting turmoil saw bond yields spike and emerging-market stocks sell off.

Jerome Powell has not repeated Bernanke’s mistakes. He has so far skilfully “avoided miscommunication” of the type that caused the 2013 tantrum, says John Authers on Bloomberg. Stocks rose following the speech; markets had feared Powell might announce a more rapid tightening of monetary policy. Instead, he remained vague on the exact timetable for tapering and made clear that outright interest-rate rises were still a distant prospect. “He managed to couple confirmation that a taper is imminent with reassurance that rake hikes aren’t.” Markets reacted positively. The Nasdaq and S&P 500 indices rose to new record highs. The latter is up by more than 22% so far this year. US government bond yields fell (bond prices move inversely to yields).

How to talk like a central banker

Powell’s speech had “something for everyone”, says Lisa Beilfuss in Barron’s. “Hiring is strong but could be better; the Delta variant may or may not be [a] problem.” Every line that hinted at future monetary tightening “was caveated by a reminder of why it isn’t” imminent. The only theme Powell really insisted on was the idea that high inflation is transient. Much now rests on what happens in September, when economists hope reopening schools will ease America’s labour shortages: “the labour shortage is the root of the everything-shortage” that is driving prices higher. The spread of the Delta variant in America may prove a “wild card” that determines whether that happens or not.

Powell’s speech was an exercise in stalling for time, says Paul Ashworth of Capital Economics. He has resisted pressure from colleagues who want tapering to begin within weeks. We think the Fed will wait until its November meeting “to announce a $15bn reduction in the monthly pace of its Treasury securities purchases and a $7.5bn reduction in MBS purchases”.

The European Union announced a $1trn landmark debt plan last week aimed at helping EU countries recover from the Covid pandemic.

The plan – the NextGeneration EU programme and recovery fund – will give loans and grants to member states and includes a rescue fund of up to €800bn and a €100bn emergency jobs programme.

It is expected to issue a total of €80bn of debt throughout the course of the year, and paves the way for Europe to develop its own regional “safe asset” bonds that could act as a rival to US Treasury bonds, the world’s go-to and most liquid sovereign bond.

So what is the recovery fund and how will it affect investors? Here’s a broad summary of the story so far.

What just happened?

The EU raised €20bn last week, from selling its ten-year bond – the first bond to fund the programme. Issuance is expected to last until 2026.

The deal attracted record interest with debt being sold at a similar scale to that of Germany and Spain, a spokesman for JPMorgan told Reuters.

What is the Next Generation EU Fund?

The Next Generation EU Fund, often simply called the EU recovery fund, is the EU’s post-Covid recovery package worth €800bn, agreed by the European Council in July 2020. Combined with the NextGeneration EU is the bloc’s largest stimulus package to date.

The value of the EU’s outstanding bonds has more than doubled since summer 2019 to €143.8bn, reports Bloomberg, reflecting a growing trend in regionally backed debt.

Until now, developing anything on par with the US Treasury bond was merely a pipe dream for EU policymakers. But this plan means EU-wide securities could replace German government bunds as the bloc’s flagship credit-market bond and gradually play a similar role to that of US Treasuries.

But if German debt is so safe, then why does Europe want another safe asset?

While German debt is classified as very safe by most big ratings providers –reflected through a credit rating of AAA – there is also a scarcity of German bunds. Also, bunds yield a negative return of 0.25%, so investors holding any bund until maturity are almost guaranteed to make a loss. Having a regional safe asset backed by all countries in the bloc is likely to make markets less fragmented.

Another big aim of the plan is to bring greater stability to European markets and eradicate disparities in the way member states price their bonds. At present, Germany prices sovereign notes against bunds, notes Bloomberg. Other member states, however, use a combination of their own bonds, mid-swaps, and market-derived interest rates to calculate the value of their bonds. Creating a safe European asset would therefore theoretically eliminate widespread pricing disparities.

What does this mean for investors?

The main result for investors is likely to be lower borrowing costs. Countries with lower credit ratings such as Italy, could stand to benefit as their debt is usually more expensive. Banks then pass on the cost to investors by hiking up interest rates. But the recovery plan will allow banks to issue loans using EU-backed collateral, driving down lending costs.

The recovery fund will also expand the bloc’s growth by 4.1% in a best-case scenario, and 1.5% in a worst-case scenario, according to financial analytics company S&P Global.

Overall, the plan is likely to boost liquidity and reduce volatility. It also makes lending easier for European banks as they can use the EU safe asset as collateral while, theoretically, lowering the risks of defaults.

What are the main challenges to implementing the plan?

There is the risk the EU reverts back to its previous position after four years. This would make achieving an EU safe asset more challenging as such a move may lead to an insufficient amount of securities required in order to generate a safe asset status.

Then there’s the chance of some wild case scenarios panning out such as a breakup of the euro area and it remains unclear how German bunds would fare in such a scenario. There is some speculation that this plan is a rehearsal for how the bloc would cope with potential defaults by high-debt nations within the eurozone, reports Bloomberg.

Why are some banks being barred from it?

The plan made headlines not just because of the bond sale but because ten of the world’s biggest banks are barred from taking part in it. Why?

Banks including JPMorgan, Barclays, Bank of America, Citigroup, Nomura, Deutsche Bank, UniCredit Spa, NatWest, Natixis and Credit Agricole have been banned from taking part until the European Commission concludes whether they have taken enough measures to fix previous antitrust breaches.

Bloomberg estimates last weeks’ €20bn issuance may have also generated €20m in fees, so the fact the banks have been barred comes at a hefty cost to them.

What is next?

The EU plans to hold two more sales in a process called syndication before August and is expected to auction bonds for the first time in September. The aim is to generate around €150bn-€200bn euros for each year of issuance until 2026 with a yield curve extending to 30 years, says Bloomberg. The EU will first issue short-dated debt to generate funds swiftly.

One of the greatest financial anomalies of the post-2008 era has been the rise of the negative-yielding bond. The idea of a lender paying the borrower, rather than the other way around, seems to turn everything we assume about finance on its head.

Yet with inflation stirring, the era of the negative bond yield might be drawing to a close. And that promises to bring its own headaches. Particularly within the eurozone.

Negative-yielding bonds are still here – but there are a lot fewer of them

Across much of the world, governments have been able to borrow at negative interest rates in recent years (and still are). In other words, investors have been willing to pay governments for the privilege of lending them money.

There have been lots of driving forces behind this. One of the most obvious is that central banks have been a constant presence in the global bond market, with the promise that they’ll always be there as the buyer of last resort.

Another has been concerns over deflation –you don’t mind buying a bond on a negative yield today if you think inflation is going to turn negative (ie, prices will fall), because that means you might still make money in “real” terms (ie, after inflation).

Finally, you’ll be happy to buy a negative-yielding bond on a purely speculative basis if you think the yield will become even more negative tomorrow, because that means the price will go up and you’ll have made a short-term capital gain. This is “greater fool” thinking which is a classic sign of a bubble.

Amid global lockdown the negative debt pile only got bigger. Indeed, as recently as December, the volume of negative-yielding debt hit a new record of about $18trn.

However, the era of negative-yielding debt might be nearing its end. Now that concerns about inflation not being entirely transient or under control are finally starting to make their way into the mainstream, buying debt that already costs you money to own, even if inflation is sitting at 0%, doesn’t seem like the brightest idea.

One region where negative-yielding debt has been a very big part of the financial landscape for some time is the eurozone. As Reuters reports, about three-quarters of eurozone sovereign bonds traded with negative yields late last year. By the end of April, that had shrunk to below 60%, and it’s only got lower since.

Most notably, the yield on the German ten-year Bund is rising fast. As the FT points out, ten-year Bund yields “were among the first in the world to fall below 0% in 2016”. Just over a week ago, the ten-year was trading at -0.2%. Yesterday it popped back above -0.1% for the first time in two years. How long before Germany – shock horror! – actually has to pay lenders to borrow money again?

To be clear, this is no bad thing. Negative yields were always a sign that something had gone terribly pear-shaped in the global economy. The idea that we might finally leave this all behind is a sign that we might get a semblance of healthy growth back in the mix (hopefully).

However, negative bond yields have proved quite handy in that they do take a lot of pressure off sovereign debt piles. Germany is not especially indebted (in relative terms). However, as you’d expect, it’s not just German yields that are rising. It’s also the interest rates on the debt of rather more indebted countries, such as Italy.

So what does it all mean?

The politics points to more tolerance of inflation everywhere

We’ve talked about how the Federal Reserve is likely to react to rising interest rates in the US. There’s no certainty, of course. There never is.

But I think it’s reasonable to believe that the Fed will be keen to push back on rising rates, even if it means instituting more radical monetary policy. It has generally paid in the last few decades to bet on the Fed being dovish.

So I’d expect the Fed to maintain the “this is transitory” line right up until it can’t. And then it might emphasise its new inflation framework to justify being more aggressive in holding rates down. The Fed has already said that it now targets a long-run average of 2%, which means it can allow inflation to rise above 2% to make up for all the years it spent below 2% in recent decades. It just needs to make the market believe that it’s entirely serious about this.

So that’s the US. In the eurozone, though, the European Central Bank (ECB) has historically had a much trickier job.

The ECB will want to keep interest rates low (or at least controlled) in order to maintain the sense of calm that has reigned since Mario Draghi managed to put a stop to eurozone break-up fears all those years ago. But Germany tends to be rather more worried about inflation than the rest of its fellow eurozone nations.

That said, some argue that the recent shift in German domestic politics – with the Greens taking the lead ahead of the elections in September – might “point to a more free-spending future”, notes the FT.

On the one hand, that would point to German Bund yields going higher still from here (if you issue more debt, you increase supply). However, it also points to a German leadership and electorate in general being a bit more relaxed about the idea of supportive monetary policy, which in turn points to an ECB that feels less restricted in suppressing interest rates.

In short, politics in both the US and the eurozone suggest that inflationary forces will be given a free rein for the time being at least. There may well be a lag in terms of policy responses – in that the ECB will probably be slower moving than the Fed – but at the same time this will probably be offset by the slower pace of recovery in the eurozone as a whole.

The pace at which each moves might affect the euro-dollar exchange rate – which we’ll look at another time – but the more important point is that the days of negative-yielding bonds may well be numbered.

We’ll be discussing this more in MoneyWeek in future issues. Subscribe now and get your first six issues free here.

“The economics of investing in bonds (and most financial assets) has become stupid”. That’s the latest message from Ray Dalio, one of the world’s most successful hedge fund managers.

Dalio is the founder of Bridgewater Associates, which is one of the most successful hedge fund groups in the world. That doesn’t mean Dalio gets everything right any more than Warren Buffett gets everything right. But it does indicate that his opinion is worth at least a listen.

So what’s he suggesting instead?

The bond bull market might already be over

The bond bull market of the past 40 years may well be over. The real (after-inflation) yield that you can get on bonds is the lowest ever right now, says Dalio. If you buy most developed-world sovereign bonds then “you will be guaranteed to have a lot less buying power in the future”.

The big risk now is that the world owns a great deal of this debt, just at the time when it’s more overpriced than ever before. This is all part of a very long cycle, notes Dalio, which has been driven to its climax by the efforts of governments to spend their way out of the Covid-19 recession.

Moreover, there’s another cycle at play – that of today’s superpower, the US, being challenged by a rising power, China. It’s the fact that the US has been top dog for such a long time that has “allowed the US to overborrow for decades”. US dollar bonds account for “over a third of global bond holdings”. A long way behind that, you have euro-denominated bonds.

Today however, China is on the rise as a competing superpower. And increasingly, big international investors are starting to put some money into Chinese bonds. Not much – “only about 6% of allocations in global portfolios” – but it’s a start.

This reflects a lot of different factors, including the fact that Chinese bonds yield more. But it’s also because the Chinese financial system is developing, and because the clear long-term desire of the Chinese authorities is to internationalise the yuan, and turn it into a reserve currency.

To my mind, that has interesting political ramifications beyond the whole “rise of empires” thing. Can China really internationalise the currency while maintaining the level of control over the economy and its own population that it desires? I’m not sure. That’s probably one reason why it’s so keen on digitising the yuan as well. But this is all a separate story for another day.

In any case, Dalio makes the point that we’ve got all of these big issues coming to a head right now. There are a limited number of ways for central banks and politicians to manage it. And that will have a big impact on investors.

So what can you invest in now?

Now, it’s worth bearing in mind that plenty of people thought that Japanese government bonds couldn’t go any lower in the 1990s and 2000s, and they did. So, while high-conviction pieces like this can be very compelling reads, you have to remember that lots of confident forecasts end up going nowhere.

But given where we are right now, I also think it’s a mistake to dismiss what seem like extreme views. It’s very difficult for us to see how far we’ve already come in terms of what would have seemed “unthinkable” at the start of this century. Central banks printing money? Unthinkable. Governments sending money direct to individuals? Unthinkable.

What’s the next “unthinkable” thing that will happen? Well, one very obvious option is for central banks to ignore inflation and instead use their money-printing and regulatory powers to hold yields on debt down, while the owners of said debt pay a huge inflation tax.

There is also, says Dalio, the risk of capital controls (in other words, you won’t be able to send your money around the world as easily because it’ll be needed at home) and also much higher taxes. He’s writing for a US audience primarily, but it’s easy to see all of these things applying to most developed economies - potentially.

So what on earth can you invest in at this point? Dalio concludes that “a well-diversified portfolio of non-debt and non-dollar assets along with a short cash position is preferable to a traditional stock/bond mix that is heavily skewed to US dollars”.

What does that mean? Overall, Dalio is saying that you shouldn’t have as much exposure to bonds as might once have been deemed traditional. He’s also arguing that US investors shouldn’t have as much exposure to the US dollar as they probably do.

For UK-based and private investors, this take isn’t quite as helpful. Dalio isn’t keen on cash because he thinks it’ll be devalued. To my mind though, all private investors need cash because of the “optionality” (that’s a fancy word for flexibility) it gives you. So I wouldn’t worry about that too much.

In terms of bonds, as I’ve said before, no one gets everything right. But it’s certainly not a good time to be “overweight” them in your portfolio.

In the “real” assets side of things – we are keen on UK stocks right now because they’re cheap relative to the rest of the developed world. I’d also still be keen to hold some money in gold – despite the risks of capital controls – because we’re not there yet (and it’s worth noting that unlike the US in the 1930s, the UK has never made owning gold illegal)

Also note that Dalio is specifically bullish on Asian emerging countries versus “assets in the mature developed reserve currency countries”. We have an in-depth piece on one very specific and dynamic emerging Asian country – Vietnam – and how to invest in it, in the current issue of MoneyWeek magazine.

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Various central banks have meetings this week, including the Bank of England and the Bank of Japan. But the biggie, as always, is America's central bank, the Federal Reserve. It has a very tricky tightrope to walk this time around.

We've been talking about inflation, the bond markets, and market perceptions of what'll happen next a lot in the last few Money Mornings. But that's because it's important.

Of all the things that are likely to trigger the next correction in markets, a confrontation between markets and central banks is the most obvious.

Why the taper tantrum could be repeated

We saw this in 2013, with the “Taper Tantrum”. What happened back then is that the US was (finally) coming out of the financial crisis and then-Federal Reserve governor Ben Bernanke hinted that it might be time to unwind quantitative easing (QE). Markets promptly threw a wobbly. Bernanke either back-tracked – or “clarified”, depending on how you prefer to put it – and markets regained their composure. Eventually QE was unwound, but at an incredibly gentle pace.

The core point was always for the Fed to lag behind the markets – to always be less aggressive than the markets expected, and to make sure that markets knew they'd be there to catch them the minute they fell. That “gently does it” approach continued into Janet Yellen's time at the top of the Fed.

Yellen eased markets into the idea that interest rates would start to rise. When Jerome Powell took over from her, he continued to raise rates through 2017 and 2018. But he eventually pushed markets to the point where they thought he was moving too fast. As a result, in early 2019, he cooled off and then in mid-2019, started lowering rates again.

Powell has learned his lesson – to an extent. He's not planning to rattle markets again with any “hawkish” lines. He's been very clear that the Fed is not fazed by inflation and expects rates to stay low for a long time. However, this won't cut it anymore. Markets are looking at all the stimulus getting pumped into the economy, particularly in the US, and they think that inflation and a strong rebound in growth is on the way.

That's one reason why bond yields have been rising, and why some have even declared the lengthy bond bull market to be definitively over. Indeed, according to Bloomberg, as measured by at least one popular bond exchange-traded fund (ETF), the iShares 20-plus Year Treasury Bond ETF, bonds are now in a bear market (as measured by a drop of 20% from the most recent high).

So far Powell's approach has been one of: “Nothing to see here, folks”. He's not really addressed the rise in bond yields or inflation expectations, trying to stick to the view that he'll look through them.

That's not sustainable.

The Fed needs to draw a line in the sand or markets will force its hand

The problem now is that markets simply don't believe the Fed's view of things. Powell and the Fed don't think that inflation will rise sharply enough to require any tightening of monetary policy in the near future.

Markets are saying that they think this scenario that he's presenting is wrong. They think something different is going to happen. In effect, markets are telling the Fed: “You're wrong. Inflation is going to rise more quickly than you think. As a result, you're going to be pushed into raising interest rates more quickly than you think. And this is what we're pricing in.”

Powell may genuinely think that markets are wrong on this. He's entitled to his view. It seems equally likely to me that what he really means is that even if markets are right to think that inflation is going to go up faster than he's predicting, it doesn't necessarily follow that interest rates will go up too.

However, he hasn't made that clear enough to force markets to sit back down.

What markets really want to hear is: “Look, even if you lot are right – and I think you're wrong – we'd ignore inflation anyway.” And they want him to set parameters on that.

But the reason he hasn't made it clear goes back to what we said on Friday about the European Central Bank: it's difficult for a central bank to out-and-out admit that it's going to run the economy hot. Or more explicitly, that it's going to ignore inflation, certainly until it becomes politically untenable to do so.

I suspect that we're now reaching the point where the market will force the issue. There are a couple of classic ways out for the Fed from here.

One, it can change the target in a non-official but pretty explicit manner. When the 2013 tantrum happened, Bernanke shifted focus to the unemployment figures, and indicated that the Fed would want unemployment to drop to a certain level before it even considered tightening monetary policy. That's definitely an option and it seems like a good one to me, given that the Fed's mission has already been changed along these lines, to make employment the main focus.

The second classic is to rely on the fact that bond yields rising in themselves tighten monetary policy. If the Fed feels that rising bond yields jeopardise the recovery by tightening financial conditions, then the central bank can push back against that too.

Neither of these options involves explicitly saying: “We won't raise rates until inflation is at 5% or above sustainably” but both of them make it clear to markets that it's time to back off.

If we don't get a message with that sort of clarity on Wednesday (in the evening, British time), I suspect that the pace of the bond sell-off would pick up and we would probably see some spillover into stockmarkets. I think the Fed would then feel forced to act more aggressively to put a floor under things.

As a long-term investor, you don't have to worry about these bumps along the way. But make sure you have your eyes on any assets you might be keen to buy at cheaper prices, because it's possible that the Fed will create an opportunity to do so later this week.

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On Saturday, Joe Biden’s big stimulus package cleared its first major political hurdle. The US House of Representatives gave the go-ahead to the $1.9trn coronavirus relief package. It now needs to get passed the Senate. The US has already spent 16.7% of GDP on measures to help the economy, notes Capital Economics. This would push it up to as much as 25%. That’s way bigger than in the eurozone, for example. It’s small wonder that investors are starting to worry about inflation.

As Neil Shearing of Capital Economics points out, not only is fiscal stimulus bigger in the US, the “degree of economic slack” is probably smaller than in the eurozone too. So you’ve got a big demand hit coming, and supply isn’t necessarily there to handle it. So you can see why bond investors are a bit rattled.

“Bonds are not the place to be these days”

Markets have calmed down somewhat this morning, but there’s every chance that it’s just a bit of calm before the next panic. None other than Warren Buffett provided a bit of perspective in his latest annual letter at the weekend, and it wasn’t comforting: “Bonds are not the place to be these days. Can you believe that the income recently available from a ten-year US Treasury bond – the yield was 0.93% at year-end – had fallen 94% from the 15.8% yield available in September 1981?”

That shows how long this trend has been running for. It also gives you some sort of idea of how disruptive it might be when it reverses. However, it’s also why we shouldn’t assume that central banks will take it lying down.

Some notable action has been taking place in a market that most of us don’t often pay much attention to – the Australian government bond market. The Reserve Bank of Australia today “doubled down on bond purchases”, as Bloomberg reports. The central bank decided to buy more than $3bn-worth of longer-dated Aussie government bonds. That followed on from a burst of extra spending at the end of last week.

What does all that mean? The Australian central bank is telling markets that it won’t allow interest rates to go up too quickly or by too much. This is what’s known as “yield curve control” or YCC, and it’s an acronym you should probably get familiar with, because you’re going to see a lot more of it in the next few months, all over the world.

Yield curve control is likely to spread

In the old days (pre-2008, or GFC (global financial crisis) Year Zero as we may one day rebrand it), central banks focused on setting short-term interest rates. Long-term ones (in other words, government bond yields) were allowed to please themselves, and served as useful indicators of market expectations. Gradually, in the post-GFC era, central banks started to control interest rates further and further into the future, using quantitative easing (QE) to buy longer-dated government bonds. YCC is the next logical step. It’s something the Bank of Japan has already been doing for a long time.

The big difference between YCC and quantitative easing (QE) is this: with QE, the central bank says it will spend a certain amount of money on bonds. Driving down interest rates on the bonds is part of the process, but there is no explicit target. With YCC, the central bank specifically says that it wants interest rates (in other words, bond prices) to stay at a certain level, and that it will buy (or sell) as many bonds as necessary in order to get to that level.

Several central banks have already started doing this. In 2016, for example, the Bank of Japan (BoJ) decided to use YCC to keep the yield on the ten-year Japanese government bond at around 0%. It has worked, in that investors realise the BoJ is serious, and therefore don’t try to test its resolve by pushing out of the 0% area. In turn, that means the BoJ hasn’t had to buy as many bonds as it might otherwise have done using QE. Meanwhile, in March, as central banks reacted to the coronavirus going global, Australia adopted a more limited form of YCC, targeting an interest rate of 0.25% on three-year bonds.

Both the Federal Reserve and the Bank of England have treated the recent surge in yields as more of a healthy correction. That’s not necessarily a bad idea, given that yields are only now back to where they were just before the pandemic upturned everything. You could argue that in effect, we’re only back to “normal”. But of course, it’s “normal” plus a load of economic damage plus a load of government spending that we wouldn’t otherwise have had. I suspect that it’s only a matter of time before investors start to push against this apparent comfort zone.

I’ll be interested to see how long the apparent insouciance lasts before the Fed gets on board with its Australian and Japanese peers. Once it becomes clear that interest rates will be held down artificially, that’s when the inflation trades will really start to take off.

We’ll have more on this in the coming issues of MoneyWeek magazine. If you’re not already a subscriber, get your first six issues free here (plus a special free bonus downloadable report on bitcoin).

In 2013, the US economy looked as though it was properly recovering from the financial crisis. So the Federal Reserve chief at the time, Ben Bernanke, decided that it might be a good idea to stop printing quite as much money.

He told markets this. They threw a major wobbly, known as the “taper tantrum”. The big question today is: are we heading for a repeat performance?

The taper tantrum, part II?

The ten-year US Treasury bond now yields about 1.4%. In other words, the US government will pay you 1.4% interest a year if you agree to lend it money for a decade. In the grand scheme of things, that's a very low number. Before the start of 2020, you had to go back to the big deflation panic of 2016 (when Britain voted to leave the EU) to find the yield anywhere near that low. Prior to that, you're looking at the 1940s.

However, as you might have noticed, 2020 was an odd year. When the global pandemic took hold, US Treasury yields ended up plumbing never-before-seen depths. In March last year at one point, the yield fell to less than 0.35%. And in summer it was still sitting around 0.5%. So while the yield on the ten-year is still extremely low, it has just about tripled in the last six months. That's a rapid move in a very important price.

Why is it moving higher? Because markets expect a strong recovery for the US economy. On top of that, they expect the US government to push through more “stimulus”. And on top of that, some expect the US government to go further and spend a lot more money on “greening” the country's infrastructure.

If bond yields rise because markets expect strong growth, that's probably not going to cause markets a major headache in the short term. But there's another reason why bond yields might rise, notes Oliver Jones of Capital Economics - and that's if they think that the Federal Reserve is going to tighten up monetary policy earlier than expected.

This is what happened in 2013's “taper tantrum”, when then-Fed chief Ben Bernanke rattled markets by attempting to map out an exit from quantitative easing, in response to an improving US economy.

So what's going on this time? Markets do seem to be rattled. The Nasdaq in particular has struggled over the past few days; gold prices have done likewise. So is another spasm of panic on the horizon?

How to play a more inflationary environment

The main issue here is not so much nominal interest rates, it's “real” rates (ie, interest rates after inflation). The main worry for markets is that rising real rates mean that monetary conditions are getting tighter in “real” terms. But if inflation keeps rising along with nominal interest rates then markets will find it hard to find reason to panic. That's more of a simple “return to normal” (or a return to levels seen before the pandemic, which were still pretty unusual).

As Jones points out, this seems the more likely scenario for now. The US government is planning to spend a lot of money. And yesterday, current Fed chief Jerome Powell reassured markets yet again that he has no interest in tightening monetary policy any time soon. He emphasised that he's not worried about the US government's $1.9trn stimulus package causing inflation.

“Inflation dynamics do change over time, but they don't change on a dime”, he told US politicians this week, quoted in the FT. “We don't really see how a burst of fiscal support or spending that doesn't last for many years would actually change those inflation dynamics.”

He's also been emphasising the Fed's employment target over the inflation target very heavily. So he's talking a good game. Will that be enough? I suspect so, for now at least. Investors are likely still underestimating the size of the recovery, and the scale of the inflationary comeback.

The Fed's main challenge probably still lies ahead – the need to convince markets in the coming months that it won't react to that rise in inflation, and instead look through it to some imaginary future where it goes down.

ING points out for example, that by May, even with relatively benign inflation readings, headline inflation in the US will easily rise above 3% and it could end up as high as 4%. And as we get beyond summer, “we could see real pressure on the Fed to justify what it's doing”.

Things might get tricky then. You'd probably need to see the Fed make an explicit commitment to stick to its employment target rather than its inflation target (which is what I suspect the emphasis will be). You might also then end up needing some sort of yield-capping strategy (ie, committing to buy more bonds) from the Fed to keep rates from spiking.

What does this mean for investors? Unless you're a day trader (bad idea) then you don't need to worry too much. I suspect markets will be edgy over the next few months and will eventually force the Fed to prove that it's serious about allowing inflation to run free.

But in terms of how to invest in a more inflationary, higher growth world, the most obvious option in terms of how to invest in this on the equity front, are value stocks, for reasons I've explained before. As investment bank Goldman Sachs notes, cyclical stocks have rebounded. But value stocks “still languish on a relative basis compared with their typical recoveries”.

We've written more on one of the best hunting grounds for cheap value stocks in the next issue of MoneyWeek magazine, out tomorrow. Get your first six issues free here if you don't already subscribe.

The arrival of the pandemic last spring sent investors flooding into the traditional safe haven of government bonds. That sent bond yields, which move inversely to prices, plummeting. By August the US ten-year Treasury was yielding just 0.5%.

Positive vaccine news means bond yields have been ticking back up since the autumn, especially in America. Investors are selling out of government debt instruments to buy into growth opportunities in other asset classes. Rising inflation expectations also mean bond investors demand higher yields as protection against the risk that their income stream is inflated away. Finally, massive US government borrowing increases the supply of bonds in the market, which lowers their prices and raises yields. The 30-year US Treasury bond is back above 2% for the first time since Covid-19 began, says Alexandra Scaggs for Barron’s. The benchmark US ten-year note is now above 1.2%. Rising yields pose a challenge to the equity bull market. They could tempt investors away from shares. Savita Subramanian of Bank of America says 70% of S&P 500 firms pay a higher dividend than the ten-year Treasury at present. That proportion would fall to 40% if the ten-year yield climbs to 1.75%, which could prompt a rush out of stocks.

Investors have long complained that poor bond yields force them into stocks in search of an above-inflation return, says Katie Greifeld on Bloomberg. Yet a recovery this year will raise pressure on the Federal Reserve to end its asset purchase programme and could even lead to talk of interest rate hikes, which will send bond yields higher. The days of Tina – “there is no alternative”– to buying stocks may be drawing to a close.

The world of gilts, otherwise known as UK government securities, is seen as exceedingly boring.

That's as it should be. This is developed world government debt we’re talking about. The whole point is that it’s the absolute opposite of exciting – it’s stolid and extremely low risk.

But in May this year, something truly extraordinary happened. Something which shook the UK bond investment community to its core.

The astonishing rise of negative-yielding bonds

In an auction in mid-May, the British government’s Debt Management Office sold £3.8bn-worth of three-year gilts at a yield of negative 0.003%.

The jargon used here can sometimes sound a bit confusing. But the bottom line is extraordinary – if a bond has a negative yield, as this one did, it means that the British government is effectively being paid to borrow. Initial investors in that bond would get back slightly less than they paid, assuming they hold the bond to maturity in three years’ time.

The casual observer might be forgiven for thinking that this was an oddity, generated by cautious investors reacting to the Covid scare and thus simply desperate to find a safe haven for their cash.

That rationale certainly explains one reason why you might buy a bond on which you are guaranteed to lose money – that you’re so desperate to put it somewhere “safe” that you’ll pay a government with a good credit rating to look after it.

But this gilt sale was no exception. As interest rates around the world have fallen, the total value of bonds with negative yields has surpassed $15.6trn. That’s something like 28% of the Bloomberg Barclays Global Aggregate Universe.

That’s still “short of a $17trn peak [seen] last year”, according to a Bloomberg report from the summer of 2020. And yet it goes to show the scale of the phenomenon, which is extremely unusual, to say the least.

What’s driving this trend towards negative bond yields?

Europe is at the centre of this peculiar trend. Interest rates on German government bonds (Bunds) have been in negative territory for months now. But even some of Italy’s government bonds – regarded as far riskier than Germany’s – have been trading at negative yields. Even some corporate bonds now have negative yields.

And note that, while the pandemic triggered another slide in yields as investors rushed to the relative safety of bonds, the rising volume of negative-yielding bonds far predates the Covid-19 outbreak. Indeed, by mid-2016, around 60% of eurozone government bonds already had a negative yield.

So there are obviously longer-term structural forces at work driving this trend.

There has certainly been a very long-term trend for interest rates to fall over time, and the difficulty that both governments and central banks have faced in keeping economic growth going, and challenging deflation since the financial crisis of 2008, has played a role.

That said, it's not easy to separate this long-term trend from the radical action taken by central banks in the last decade. Quantitative easing (QE – where central banks “print” money to buy assets) has certainly played an important role, by driving up demand for bonds from central banks, eager to buy assets for their balance sheet.

The European Central Bank’s pandemic programme totals €1.35trn, while the Federal Reserve is buying about $80bn of bonds a month. Also, several G10 economies have cut policy rates to below zero – in other words, central banks have set short-term rates negative. Recently there has been talk of the Bank of England doing likewise.

Bonds that cost governments absolutely nothing – indeed, that they get paid to issue – sound like an amazing gift, and many have urged governments to take advantage. But there are very real potential risks.

Negative interest rates, for example, erode the profitability of banks, which risks in turn reducing the availability of credit in the economy at a time when banks’ resilience is much needed. Banks have sought to offset negative rates by charging higher fees, repricing mortgage spreads and, in some cases, lending more aggressively (and thus exposing themselves to higher bad debt risk).

Negative bonds might also prove a long-term threat to the solvency of insurers and pension funds – these cautious institutions need a positive return in order to be able to fund their long-term policy commitments, usually by investing in a combination of “safe” gilts and less safe corporate bonds. If both are negative yielding, they might be tempted to take undue risk to goose up returns for policyholders.

What’s indisputably true is that if the sheer quantity of negative-yielding bonds keeps increasing and then stays at these yields, we are all collectively storing up trouble for the future – which is, ironically enough, one reason why central banks are printing money and slashing rates so frantically in the first place.

One last key point: bond investors and bond fund managers are not necessarily doomed in a negative-yield environment. For starters, investors can make money by buying positive-yielding bonds which subsequently turn negative, or even by buying bonds which are already negative yielding, but then experience even sharper declines in the negative yield.

The point is that bond prices move up and down in value, so it’s not just about the income – there are the potential capital gains to be made should rates turn even more negative.

Also, there are still plenty of bonds paying positive yields, thus providing investors with some income – US Treasury bonds, for instance, still offer positive yields across the board, as do most corporate and emerging-market bonds. We'll take a closer look at emerging-market bonds in our next email in this series, next week.

Investors and politicians have been worrying about government debt for decades. In the 1990s, “debt clocks” – which showed just how just much that mountain of debt was increasing every second – became extremely popular, with some clocks in the US displayed on the side of buildings.

The not-so-subtle message? It’s only going one way: upwards! And it did. The question now is: how will we pay it back? And how might that affect investors’ pockets?

Our debts are only going to get even bigger

Back at the start of the 2000s, we were worrying about aggregate UK government debt hitting the £500bn mark (which happened in 2007). According to government statisticians, it’s currently standing at just over £2trn and is likely to head significantly higher in the coming months.

As that number has inexorably climbed, a related concern has emerged: who’s buying that extra debt? The answer is that a growing proportion is ending up on the balance sheet of the Bank of England. And strategists at investment bank Jefferies have suggested that the central bank will end up backing the vast majority of government deficit financing.

The pandemic isn’t entirely to blame for this state of affairs. For the last decade, central banks across the globe have been boosting their balance sheets by buying securities including corporate bonds, exchange-traded funds, and government bonds. This so-called quantitative easing (QE) has merely intensified in the Covid era.

Researchers at CrossBorder Capital have suggested that the huge monetisation of deficits planned by central banks will see the size of their balance sheets jump by a third, potentially resulting in “15%-20% monetary growth in 2020” which in turn “surely must lead to faster inflation of circa 5%-10% in the US from 2021”.

At this point, many economists suggest we should stop worrying. Monetarists might worry about future inflation (due to too much cash chasing too few goods and services), but those influenced by eminent economist John Maynard Keynes’s views argue that this is all to be expected – and encouraged.

If we are to avoid deflation and a “doom loop” whereby falling demand leads to higher unemployment which in turn weakens demand further, they say, then the government must step in and spend during periods when consumers and companies are cutting back and trying to boost savings.

If deficits rise but growth picks up, the government will benefit from a higher tax take, which should help balance the books. And if all else fails, increased inflation can help depreciate the real value of all those debts.

The rise of Modern Monetary Theory (MMT)

Even many classic Keynesians accept that there must be a limit to this deficit-fuelled expansion. But ongoing subpar growth and low inflation in recent years has emboldened a new, radical breed of economists, with a new set of proposals.

They suggest that governments can print money almost without limit (bar rampant inflation) and can thus innovate with new ideas such as sending government cheques direct to taxpayers (as the US government has already done).

This radical school of thinking even has its own term – modern monetary theory (MMT). One of its foremost proponents is Stephanie Kelton, a professor of economics at Stony Brook University and senior economic adviser to Bernie Sanders’s presidential campaign.

She and other MMT-ers argue that a government which can issue its own currency need never default, since it can always print pounds or dollars to repay gilts or Treasuries, say. So the only real limit to government spending is not the deficit, but inflation.

In the absence of inflation, what could all that extra government debt be used to fund? In Kelton’s recent bestseller, “The Deficit Myth”, she argues for a “people’s economy” which includes a Green New Deal; a guaranteed job for everyone; free healthcare; free childcare; the immediate cancellation of student debt; free college; “affordable housing for all our people”; national high-speed rail; “expanded social security”; “a more robust public retirement system”; and “middle-class tax cuts”.

Kelton’s ideas are at the more radical end of academic opinion, but many central banks have already experimented with radical ideas based on quantitative easing (QE) – for example, in Japan and the US, central banks have already been buying funds containing stocks and junk bonds.

Helicopter drops of money to consumers using central-bank-controlled “e-money” accounts with all citizens are also being openly discussed in policy circles.

So while we may not end up with MMT, we may see more and more radical plans to print money to spend and give away. In those circumstances, worries about inflation from rampant monetary growth aren’t completely unfounded. Indeed, it may seem like an obvious outcome.

However, it is worth noting that the country that has thus far been most closely associated with radical monetary policy – Japan – is also more readily associated with deflation, rather than inflation.

And the fact that we are even discussing a once-outlandish theory such as MMT so openly today stems precisely from the difficulties that central banks have encountered in generating sustainable inflation.

So while it’s certainly an issue to watch, it’s perhaps also wise to be wary of taking an inflationary future for granted.

Good morning and welcome to the second in our short series looking at different aspects of the fixed-income investing world. Last week David looked at “fallen angels” – today he asks why any investor would offer to lend their money to a government for a century.

Global bond markets have grown remarkably accustomed to extraordinary events over the last few years, what with the rise of negative interest rates and yields.

But in June, the government of Austria jolted the markets by succeeding in placing a €2bn bond issue on a yield of 0.88% – for 100 years.

Yes, you did read that right. The Austrian government is borrowing money for a hundred years at 0.88% per annum.

Yet what is even more extraordinary is that this wasn’t Austria’s first attempt at issuing a cheap 100-year government bond.

100-year bonds are in strong demand

Back in 2017, Austria’s government issued a bond with a “huge” (by comparison with 2020) yield of 2.1%, for the hundred years to 2117.

The sceptic at this point might be guffawing and suggesting that this is surely an example of good money chasing bad, especially as the 2020 issue was eight times oversubscribed.

But they’d be wrong, as the subsequent price action has amply demonstrated.

The yield on this 2017 bond began dropping from that initial 2.1% almost immediately. Then in 2019 it crashed to below 1% and then at the height of the coronavirus lockdown earlier this year, it fell to below 0.5%.

This slide in yields in turn means that the price of said bond has substantially increased (when bond yields fall, prices rise and vice versa – think of it as a seesaw). Indeed, the bond now trades for more than twice its face value.

Flash forward to 2020 and the newest issue is also trading above the issue price, with a decline in the yield in the last few months. Put simply, demand for these bonds has been substantial.

And it’s not just Austria which is tapping this demand for the long-term capital - Ireland and Belgium have also issued 100-year debt (in private placements), France has sold 50-year maturities, as has Italy, while Germany is focusing on 30-year durations.

According to one estimate, in the ultra-long space, 2020 has already seen more issuance in the 100-year maturity area than for all of 2019. But not every country has jumped on the bandwagon – earlier this year US Treasury Secretary Steven Mnuchin said that the US government had shelved plans to issue 50-year bonds because there was little interest among investors.

According to Mnuchin: “we went out to a large group of investors and solicited feedback from our Treasury borrowing committee and I was somewhat surprised that the result was that there’s some interest in this, but perhaps not enough that it would make sense to issue those bonds at this time”.

But he added that the government hasn’t completely abandoned the idea. Most investors expect the US government to focus on 30-year duration bonds for the time being.

So it’s clear that what was once regarded as the preserve of emerging markets economies – both Argentina and Mexico have issued 100-year bonds in the past – has turned mainstream. And while both the US and UK governments might currently be cool on the idea, plenty of other issuers have emerged, even in the corporate world. The Walt Disney Company (DIS) and Coca-Cola (KO) have both issued 100-year bonds in the past.

Why do investors like these bonds?

One thing is clear – investors right now are keen on these bonds, which are described as “ultra-long duration”. Why?

Firstly, Austria, like many developed world countries, is viewed as low risk, so by investing in its 100-year bond, investors are at least locking in a long-term positive return – many shorter-duration government bonds in Europe, by contrast, are currently negative yielding.

Secondly, ultra-long duration bonds also benefit from something called “positive convexity”. If you own long-dated bonds with low coupons (low payouts) their purchase price rises more sharply when yields fall.

As a note on this convexity strategy by investment bank JPMorgan puts it: “with a high convexity bond, the price falls less if yields go up, than it increases when yields go down. That asymmetry is very interesting for some investors who can use it as a hedge if interest rates, as some expect, have further to fall.” Many institutional investors or endowment funds also use 100-year bonds to extend the duration of their bond portfolios to meet certain investment goals.

Of course, it’s also worth noting that many investors don’t hold these bonds for 100 years. They might buy a popular 100-year bond, sit tight for a few months, then wait for secondary demand to push up the price.

One last footnote – in the past we have had bonds with even longer durations. Perpetual bonds issued by the UK government, known as consols, were launched in the mid-1700s, with more emerging again in the 1800s and even as late as 1927, offering yields in the 2.5% to 4% range. Some of these were only bought back again as late as 2014. However, some economists have suggested that the US government start issuing perpetual Treasury bonds as a way of avoiding any future debt repayment overhangs.

US GDP had its worst fall on record in the second quarter. It shrank by 9.5% from the previous quarter, a 32.9% slump in annualised terms. “That is... the equivalent of the first three years... of the Great Depression accelerated into just three months”, says Tim Price of Price Value Partners.

GDP is a backward-looking indicator, but US weekly jobless claims have increased for two weeks running as the virus has forced renewed closures in southern states, says Alexandra Scaggs for Barron’s. The bond market is now sending a “warning signal” about the recovery, says Giles Coghlan on fxstreet.com. The yield on US ten-year Treasury bonds hit its lowest level since early March last week, while three- and five-year yields hit new record lows. Bond yields move inversely to prices, so falling yields imply gains for bondholders.

The bond rally is perplexing for two reasons. Firstly, governments have issued vast tranches of new debt to pay for the pandemic, which would ordinarily cause their borrowing costs (implied by bond yields) to rise, not fall.

The US budget deficit hit $864bn in June, a figure Dan Morehead of Pantera Capital says surpasses “the total [US state] debt incurred from 1776 through the end of 1979” in nominal terms. In 2020 a country can rack up “two centuries of debt in one month”. Bondholders have central-bank purchases to thank for keeping yields low.

Secondly, the bond rally suggests that markets are sanguine about inflation, says Tommy Stubbington in the Financial Times. That’s partly because monetary stimulus after the financial crisis did not deliver the inflationary wave many predicted. Yet the recent gold rally suggests that concern about rising prices is growing. If the gold buyers are right, the bond market has got it “very wrong”.

The government last week sold a three-year gilt with a fractionally negative yield of -0.003%, meaning that investors were effectively paying the Treasury to borrow money from them. In a further sign that central banks’ quantitative easing is forcing market prices through the looking glass, the yield on the five-year gilt also went negative for the first time, hitting -0.003% at the end of last week.

Investors who buy and hold these negative-yielding bonds to maturity will make a small loss. Some hope that the global bond rally will enable them to sell them on at a capital gain, but others may simply have concluded that with the growth outlook shaky there are no better options.

Markets have been spooked by poor data, particularly April’s sluggish 0.8% inflation reading, says Paul Dales for Capital Economics. Yet the key factor is interest rates. The Bank of England has said that negative short-term interest rates are under “active review”. UK interest rates currently sit at just 0.1%. In every sense, the outlook has “all gone a bit negative”. Interest rates on much of the continent and in Japan are already below zero. If the UK follows suit then expect pensions annuities to fall and pension scheme deficits to rise, says James Coney in The Sunday Times. If you think the past decade has been a grim one for savers, “you ain’t seen nothing yet”.

In times of crisis, investors traditionally look to bonds to cushion the pain. Most major stockmarkets remain down on the year, while government bonds have gained ground. The yield on the US ten-year Treasury has fallen from 1.8% at the start of January to about 0.7%. Germany’s ten-year Bund yield has fallen further into negative territory, down from -0.22% to almost -0.5%.

Bond yields move inversely to prices, so falling yields imply capital gains for bondholders. The yield on the US two-year Treasury fell to a record low of 0.105% at the end of last week.

The bond market is being driven by two key forces: higher government spending and central banks’ quantitative easing (QE), says Emily Barrett on Bloomberg. On the one hand, governments are issuing vast new tranches of bonds in order to pay for pandemic rescue measures. The US government is preparing to issue a record $96bn in new bonds over the coming weeks to finance an annual deficit ballooning towards $4trn.

Bond investors would usually demand higher yields to fund all that new spending, but this effect is being counteracted by vast QE, with central banks soaking up much of the new bond supply with printed money. The Federal Reserve has bought $1.5trn in US bonds over the past two months, while the Bank of England has expanded its QE programme by £200bn.

One reason that investors are willing to pay up for bonds with such low yields is that they do not have many other low-risk places to put their cash. Interest rates sit at just 0.1% in the UK and are negative in the eurozone.

Futures markets show that traders think there is a chance American rates could also turn negative by the end of the year, says Justin Lahart for The Wall Street Journal. In such a severe crisis you should “never say never”.

Albert Edwards has copped a lot of criticism over the years for being too bearish on stocks. However, as we’ve noted before, the Societe Generale strategist has been equally stubbornly correct about one very important point which most others have got entirely wrong. He’s been a bond bull through thick and thin.

So that’s why we were really interested to read his latest report. Because now he thinks the bond bull could be very close to ending.

Politicians are embracing money printing even faster than you’d expect

Albert Edwards’ view has always been that we are in an economic “Ice Age” of stubbornly deflationary, stagnationary forces. Under this thesis, it made logical sense that US bond yields would eventually join those of all the other big economies in negative territory. (Remember – when bond prices rise, yields fall, and the other way around). And so far, that’s what has happened during the coronavirus crisis.

However, he has also pointed out that the next recession would be such a massive deflationary bust that it would result in an equal and opposite reaction from the public sector, driven by voter anger and economic chaos.

It would probably involve governments piling in with the aid of central banks and printing as much money as it takes to bail entire economies out. The shorthand for this is “helicopter money”. This would eventually turn around the slide in bond yields and result in inflation.

This, of course, is what we’ve already seen as a response from governments. And this turnaround has been so rapid that Edwards reckons we might be closer to the denouement than he’d expected. “The size and synchronisation of the fiscal and monetary stimulus represents a sea change in policy aggression… policy is transitioning to helicopter money”.

You can see it happening across the board. Politicians are planning to hand out money to citizens in the US – the initial package probably isn’t enough but there will be more where that came from. In the UK, the Bank of England yesterday went all out to ensure small and medium-sized businesses can get their hands on loans, while the chancellor is coming up with plans for protecting wages.

Even the European Union, led by Germany, is starting to look as though it might consider issuing joint government debt to tackle the crisis (we’ll see if that happens).

All of this has helped us to see an “up” day for markets so far, although it remains to be seen how long that lasts. But the intervention of governments is everywhere now — even crude oil prices have rebounded from an 18-year low on news that the US plans to buy up oil from domestic producers for its strategic reserve.

The US Department of Energy will buy the oil from small and medium-sized US producers. It so far plans to buy 77 million barrels. There’s also talk of acting to get both Saudi Arabia and Russia to stop producing as much, although it’s clear that Donald Trump wants to strike a balance between helping domestic producers and keeping petrol prices low for voters in November.

It appears that we crossed the political threshold for doing “whatever it takes” a long time ago. It’s not about the will to do it anymore (which was very much the post-2009 fight). It’s now about ironing out the practicalities (which will be difficult enough).

In short, this is happening faster than Edwards expected, and that has implications for just how bad this all gets.

The economic news is going to get a lot worse over the coming months

So what does it mean? Well, the problem is that the financial system went into this in a very fragile state. In effect, we’ve had a “just-in-time” financial system operating with no real margin of safety (bar a reliance on the Federal Reserve as the ultimate safety net). Like every other aspect of our “just-in-time” economy, this has been brought to a shattering halt by the coronavirus and our response to it.

So while “whatever it takes” and helicopter money will eventually “trigger a recovery… we collectively have no idea how deep this economic and financial market meltdown will be”.

As a result, the bond bulls may still have one last hurrah. As Edwards notes, markets are likely to panic when they see how bad the upcoming economic data is going to be. That makes sense to me.

Yesterday, new weekly jobless claims in the US surged to 281,000 after sitting around the 210,000 mark for the best part of the last two years. That’s a shocker, and it’s happening at a time when the economic downturn and the shutdowns have barely started. To put it bluntly, the data for the next few months is going to be nothing short of horrific.

As a result, Edwards says, we could well see new lows for bond yields, “with the US ten-year converging with Bund [German government bond] yields deep into negative territory.”

However, it’s possible that we won’t get that far. And as Edwards reiterates, the arrival of the helicopters almost certainly means that this recession will mark the end of the Ice Age. So he’s “keeping an open mind”.

But the overall point here is that this is the turning point. The biggest secular trend of most of our investing lifetimes – the long-term decline in interest rates and inflation that started in the early 1980s – is now in the process of ending. Whatever comes next, it’s going to have a profound impact on all of our portfolios.

We’ll be discussing this in a lot more detail in next week's issue of MoneyWeek – and we’ve got helicopter money on the cover of this week’s issue, out today.

So if you’re not already a subscriber, now’s a good time to sign up, and we’ll do our best to help you to navigate this brave new financial world. Find out more here.

This afternoon, the US stockmarket slid so hard at the open that it triggered a circuit breaker. In effect, the market was given a “time out” so that it could gather its breath.

Having reopened, the S&P 500 did seem to regain a little bit of composure – it’s now only down about 5% as I write. But it's a big deal, no doubt about it.

And yet, believe it or not, there are even more momentous events occurring in what is traditionally viewed as one of the most boring markets on the planet – the government bond market. I will admit that we have been saying for a very long time that the valuations in the bond market appear to make very little sense. But the latest moves have surprised even us.

A quick refresher. Bonds are IOUs, typically with a fixed annual interest payment (the coupon). So when bond prices go up, their yields go down (because the yield is the coupon as a percentage of the price – it’s a little more complicated than that, but this will do for our purposes).

In the last two sessions, US government bonds have made history. Regardless of how long you lend money to the US government, you are now getting paid less than 1% a year.

Other bonds are even more ridiculous. Bonds in Japan, Germany, and much of the rest of the eurozone have been in negative territory for a long time (ie, investors are – technically speaking at least – paying governments to “look after” their money for them). But now even bonds in the UK (where central bank interest rates remain positive) have dipped into negative territory across many maturities.

Bond yields this low suggest that investors are so panicked that they’d rather face a guaranteed loss than risk putting their money anywhere else.

So what’s going on? As Louis Gave of Gavekal puts it, there are really only one of two options as to what to believe when faced with moves this extreme. Either this is a “blow-off top”, the charmingly-named technical term for the fit of mania before a bubble (or long-term bull market, depending on whether you were invested in it or not) finally pops.

Or it really is different this time. In that case, perhaps "the world is facing an economic ice age” (presumably a nod to the thesis of Albert Edwards at Societe Generale, who expects bond yields to go even more negative from here as deflation takes hold worldwide).

Gave is no Ice-Ager, but he acknowledges that there are a couple of big factors that could catalyse an ice age. One is the fall-out from the coronavirus itself. And the other is the all-out war that’s just been declared in the oil market.

The latter will hit investment spending in the US as troubled shale producers scrabble for all the cash they can lay their hands on. That is likely to damage US growth and could cause further jitters in the corporate credit markets.

However, argues Gave, the bond market moves may equally have been triggered by insurers and pension funds piling in due to the need to offset their future liabilities in the face of yet more declines in interest rates. That risks becoming a self-fulfilling feeding frenzy, exacerbated by the Federal Reserve’s panicky rate cut last week.

And as James Ferguson of MacroStrategy Partnership points out, stocks – certainly in the UK – are starting to look inexpensive compared to their valuations during previous recessions.

In short, there is likely to be more turbulence ahead. But is the market over-reacting? Arguably yes – particularly if you assume any sort of government action to “stimulate” the economy further.

The Sveriges Riksbank, the country’s central bank, ended a four-year experiment with a negative interest rate policy (NIRP) at the end of 2019 amid growing concern that it was pumping up a private sector debt bubble and distorting the financial system. Market commentators said that the move could herald the start of a global trend away from NIRP. The eurozone and Japan currently have negative rates.

Yet a finance ministry report released this month was interpreted as “a thinly veiled message to the central bank” that rates should be cut back below zero, says Bloomberg. With growth expected to come in at just 1.1% this year, it seems the government is keen for some monetary support.

Weak inflation, which remains below the 2% target and is expected to fall further over the next two years, may well force the Riksbank’s hand, says Melanie Debono for Capital Economics. We think that the bank “will cut rates back below zero this year as slow growth keeps a lid on inflation”.

On the contrary, an improved outlook for global trade and an undervalued currency could yet see growth and inflation surprise on the upside, says Pierre Gave of Gavekal Research. Sweden’s small and open economy has “a habit of leading economic cycles”, making it something of a global economic “bellwether”. Keep an eye on it.

German bond yields are down to all-time lows as market turmoil causes investors to pile into sovereign debt, no matter how overpriced. The yield on the benchmark ten-year bond touched 0.219% on Monday, with investors apparently unperturbed by the negative yield. Bond yields move inversely to prices, so when yields fall even below zero that still implies a capital gain for bond holders.

Bond bullishness was not limited to Europe's most rock-solid country. Investors have even been lapping up Italian debt, notes Nikou Asgari in the Financial Times. Rome issued €4.6bn of bonds last week, with "demand for the five-year bond" at its highest level since August last year. Ten-year Italian yields hit a two month-low of 2.48% this week.

Yet Rome's borrowings have reached an eye-watering €2.4trn, or 132% of GDP. Far-right League leader Matteo Salvini recently announced plans to spend a further €30bn on a flat tax, a clear provocation at a time when the European Commission has already warned Rome about its profligacy. "Italy's debt is less sustainable than that of Greece," says Simona Gambarini of Capital Economics. "If growth in Italy deteriorates, concerns about its debt sustainability are likely to intensify." That means that, extraordinarily, "it may now be more risky to hold Italian bonds than Greek ones", writes John Ainger on Bloomberg.

The bond markets took a battering last month. A spike in global bond yields (bond prices fall when yields rise) "triggered heavy losses" for fixed-income-invested mutual funds, say Dan McCrum and Lucy Warwick-Ching in the FT. Every one of the most popular class of US mutual-bond-investing funds lost money in May as investors started to fret about the end of quantitative easing (QE). Figures from Lipper show UK bond-fund losses averaged 1.23%, with some funds losing 2.74%, according to Brian Dennehy of FundExpert, quoted in the FT.

The rise in yields has come as investors anticipate the end of the US Federal Reserve's $85bn-a-month QE programme. Fed chairman Ben Bernanke revealed last month that bond purchases aimed at keeping interest rates low may be reduced, depending on how good US economic data are. "This could have far-reaching consequences for the US debt markets," notes McCrum. Rising yields also sparked a US stockmarket sell-off late last week, says The Wall Street Journal, with stocks that benefit most from low interest rates, such as telecoms, utilities and real-estate investment trusts, taking the brunt.

Is it just a correction or is the 30-year bond bull market ending? Money continues to flow into bonds. According to Lipper, $136bn went into bond mutual funds in the first five months of 2013, compared with $145bn in 2012. Ten-year bond yields have only risen back to levels last seen in April 2012, says Jonathan Cheng in The Wall Street Journal.

Some believe the bubble has already burst. "I am now throwing in the towel," Benoit Anne of Socit Gnrale told investors in a note. "We are no longer bullish on emerging markets." He may not be the only one. According to The Wall Street Journal, Barclays estimates that investors withdrew $2.89bn from emerging-market equity funds in the final week of May.

Others are less pessimistic. "This is only a catch for breath," Ruchir Sharma of Morgan Stanley Investment Management tells the FT. "Some countries will continue to do well and some will not." Other fund managers are looking to the economic stimulus from Japan to save the day. HSBC reckons $600bn of outflows from Japanese government bonds in the next two years should benefit markets in Malaysia, Turkey and Mexico.

If the US does taper QE off, "it will be a victory of hope over data", says James Saft on Reuters.com. The US economy looks increasingly shaky. Manufacturing orders were "sharply lower" in May, with one survey showing its worst results in four years, "consistent with an actual contraction". Chinese data have also been less than compelling. Even the Federal Advisory Council a group of bankers that advises the Fed says "it may be years before QE can be scaled back". Minutes from its 17 May meeting state that QE is "likely [to] continue for one to three years". With the US recovery far from steady, the Fed is unlikely to risk a recession.

For the policy to change, the Fed will want to see consistently better data. Instead, Bernanke's hints are pure posturing, aimed at getting investors used to the idea that QE will eventually end, says Saft. "Financial markets seem to view the tapering talk with a mix of reflexive cynicism and gripping horror," he notes. But it's possible to chalk this up to "expectations of the slaughter which would happen when its main customer [the Fed]... provides less support".