Macro Overview

11/05/26 – 18/05/25

The British gilt dilemma:

Gilt yields have soared as piling political pressure on Keir Starmer to resign sparked a major UK bond sell-off. 30-year gilt yields have hit 5.81 per cent and UK borrowing costs have hit their highest level since 1998 – also attributed to inflation fears surrounding the ongoing Iran war.

It is worth stepping back and understanding why bond investors were so spooked by the prospect of Keir Starmer’s departure from office. Recent history has proven time and time again that political instability sparks a gilt sell-off. Underlying this is the prospect of uncertainty, which bond investors are tremendously afraid of. Bonds are widely seen as a safe, predictable investment in developed economies such as Britain, given their guaranteed fixed payments upon maturity. However, a potential change in premiership creates an uncertainty for lenders as they are no longer sure who the next leader will be, meaning an uncertainty over future policies (more on this below). This can prompt a sell-off of bonds in the market by lenders as they feel the existing yield rate does not reflect the unpredictability they face. As such the supply of bonds rises and the price falls, causing a rise in gilt yields, and as such rising borrowing costs for the government as noted.

There are two core ramifications of this on the British economy. In the short-term a great concern is a rise in the rate of newly-issued fixed payment mortgages. Mortgages are tied to gilt yields through swap rates: since the 2008 financial crisis banks have looked to cover against potential changes in interest rates when issuing fixed payment mortgages by paying a variable rate based on gilt yields to investment banks. As such if gilt yields rise then swap rates rise, and with that the costs bared by mortgage-issuing banks increase, leading to higher rates on fixed payment mortgages issued until swap rate losses are recovered.

The longer-term consequence of increased gilt yields is the higher borrowing costs faced by the UK government. The IMF has recently urged the government to ”keep cutting their deficit” (FT) which stands at £12.6 billion per month. If the government continues to borrow at their previous per annum rate – 4.3% of GDP – the quantity of debt owed to lenders as a proportion of GDP will increase significantly over time. As a greater proportion of funds is allocated to the repayment of debt and fiscal headroom tightens, a reduction in spending on public services and infrastructure becomes more than likely. There also remains the more subtle implication of a rising corporate borrowing floor. Bonds are treated as the ‘risk free’ benchmark for the entire UK financial system, and as such corporate bond yields must climb even higher to remain attractive. This raises future costs for the UK’s own firms, minimising domestic growth as firms will downsize investments on the basis of steep borrowing costs. Arguably these longer-term consequences are worse – the post-Brexit Britain has already overseen fleeting investment and ongoing stagnation. We cannot afford it getting much worse.

Despite Starmer appearing impervious to calls for his resignation, it would not be unwise to look at the implications other potential leaders – and their respective policy stances – could have on the gilt market. Andy Burnham – given a 54% chance of succeeding Starmer this year on Polymarket – is regarded as the furthest left of the prospective candidates. He has previously advocated for greater council housebuilding, exemptions on increased defence spending (as per the German model), and worries the UK need to stop being so ‘in hock to the bond market’. You won’t be surprised where I go from here. This could prove problematic for gilt investors as Burnham appears to have touted a rise in spending, bringing with it the prospect of fiscal indiscipline. This would stimulate further government borrowing, a rise in the supply of bonds, and mark to market losses for those holding existing (lower-yield) gilts. Indeed, Cathal Kennedy (senior UK economist at RBC Capital Markets) this week told the FT that it is the potential departure from the Labour government’s fiscal rules that is “hurting the long end”. But who knows – politicians aren’t notorious for doing what they say they will; the Burnham campaign has now stated that “changing the fiscal rules (is) no longer an option” (BBC).

Wes Streeting – currently second favourite to overthrow Starmer – is viewed as the more calming option for gilt markets – given his alignment with Starmer in pledging to lower debt as a proportion of GDP by the end of parliament. Nonetheless, gilt investors could be set for an unpleasant surprise as he may need to stray from the policies of Starmer and move to a more fiscally loose strategy to appeal to those on the left in the future. It seems the only way is up, up meaning yields of course.

It would be easy to end this week’s macro insight by simply decrying the impact of political instability on borrowing costs. Or I could helplessly call for Burnham to shift a tad to the right in order to prevent rising yields and the trickle down ramifications that come with them. While there is no harm in this, is political instability not part and parcel of every economy? Burnham seems unprepared to deviate from fiscal guidelines and so I would argue that gilt markets are frantically overreacting. As such, it may be of more value to investigate the ease at which lenders are ready to pack their bags and dump British gilts at the slightest sign of political strain. My thesis is that this is the consequence of a mass internationalisation of British bonds. Almost one third of gilt investors are profit-driven foreign hedge funds with no emotional incentive to hold UK debt during periods of uncertainty. Without higher domestic investment in gilts, the cycle of instability-to-sell-off will only grow more volatile. Alas, in fear of this spiralling into a dissertation, I will save the rest for next week. See you then.