Spiralling Gilt Yields Spell Trouble for the UK

Hello and welcome back to The Trading Floor, the first episode of 2025. So welcome back, Piers. And as per usual, I know you're a big fan of sensational headlines, so I thought we could start the year, start the year with a bang. And I thought I'd give you a flavor of what the UK press are running today, recording on the Wednesday, the 8th of Jan, which is as follows. Ready?

I'm ready. Hit me.

The pound plunges as borrowing costs surge even higher. Benchmark 10-year yields in the UK have jumped 12 basis points, now at their highest level since August of 2008. The pound has been crushed against all of its group of G10 peers, slumping more than 1% versus the US dollar, while UK domestic shares have tumbled. With the FTSE 250 mid-cap stock index heading for its worst 2-day slump since August. Welcome back, Piers. Wow.

Well, obviously everyone listened to my comments on the episode just before Christmas. You know, Armageddon is here. Yeah, I mean, look, obviously, yeah, so you always, you know, it's a good reminder. You've always got to be a little bit— take these headlines with not a little bit, a lot of, a very large pinch of salt. You know, I love the fact— what my favorite one out of all of that was, the pound's getting crushed and it's down 1%. It's like, oh, okay. I mean, crushed. I mean, come on. What's that, 10, 20% crushed in my mind? But yeah, look, sensationalist stuff gets the clickbait. But I would say in this instance, you know, there's no smoke without fire, and there's definitely some very notable market, uh, price points that are getting reached, uh, today. It's been a direction of travel for a while, and now— and I'm talking bond yields And that's where I want to zoom in on specifically for this episode, because we are at levels that are quite remarkable. And there's, you know, there's some counterintuitive-y in there, and that's not even a word. But yeah, I guess for me, that 2008, one of the kind of lines you just said, 10-year yields hit their highest level since 2008. So here we're talking about bonds, right? We're talking about specifically UK government bonds. We call these gilts, uh, certainly on the long end. And we have different duration of bonds. So these are loans, it's the government borrowing money to fund their fiscal spending, right? And so, and they're borrowing money over different time periods. Uh, typical ones, 12 months, call these kind of T-bills, uh, 2-year, 5-year loans, 10-year loans, out to 30-year loans. Okay, that's the longest sort of duration loan that the UK government will, um, borrow over. Okay, and when you get out to the long end stuff, and we call this the long end of the curve because actually when you look at the different yields of bonds of those differing durations, so let's say 12 months out to 30 years, and you plot on a chart all the yields for all the different durations as you go out in time. Okay, and this is called the yield curve. And we often look at the yield curve as a really, you know, for many reasons, but it's a good kind of powerful indicator as to, you know, general economic health, you know, the health of the government and their deficit and their debt levels, the health of the, yeah, the UK underlying economy, the inflation and interest rate situation today, and what we think is going to happen with those two things in the future. All of this stuff kind of gets embedded into bond yields, and this yield curve paints a great picture of how is, you know, it's a health check. All of those things, where are we at? And what's happening is that the long end of the yield curve is going up, and it's actually just accelerated to the upside. So to be clear, Yields on the long end have been going up for 3 months, okay? And they've accelerated as we've turned the year. And the most notable for me was the 30-year yield. So the 10-year yield, highest since 2008. 30-year yield, it's actually the highest since 1998. So what I guess the questions are, well, why is it that high? And what does that mean for people?

Yeah, you said it was counterintuitive. So I'd like to get into that because we're in a rate-cutting actual cycle. So I'd like to first tackle some clear defined points first.

Yeah.

Why is this happening? So why over 3 months and why the acceleration?

So I would say that, again, I'm going to simplify here. So again, thinking about that yield curve, so you think about the short end and the long end. So the short end, those shorter time frames, 1-year, 2-year loans, right? Um, and then the long end is like 10-year, 30-year. Okay, think about those two. The way I've always thought about it, to simplify it, is the short end of the yield curve is most sensitive to interest rates. So that's the central bank. What are they doing with interest rates? They're moving them up or down. How— where have they come from and where are they going in the future, right? And that— so short-term yields will be most sensitive to that. And when interest rates are going up, the short end of the yield curve goes up. So bond yields are correlated to interest— to the central bank interest rate, okay? If you like, you could say the central bank's interest rate is really a reference rate for for 2-year loans. So if banks out there are providing loans to consumers or to businesses, you know, what interest rate are they going to charge on those loans? What is the cost of borrowing is referenced off, well, what's the Bank of England's interest rate? Let's start there, and then normally you add some basis points. So if you're a bank lending money to your customer, you're going to lend it at an interest rate of base rate, that's the Bank of England rate, 'plus 100 basis points,' so plus 1%. Okay, and that's the interest rate I'll charge to my customer. So the short end is geared on interest rates. The long end of the curve, much, much, much more controlled and sensitive to inflation. And that's just because of— think about it, if you're going to buy a UK 30-year government bond, you're going to essentially, in principle, you're lending the government money for 30 years. If you lend them a million pounds, right, and they've got to pay me back in 30 years, but they're going to pay me back 1 million pounds. But the problem for me as an investor, the risk for me is, well, how much is a million pounds worth in 30 years' time? Because the cost of money changes because of inflation. Prices of stuff goes up. So likely that 1 million to me in 30 years is a lot less valuable than 1 million to me now, right? But how much less valuable? That's the bit that you have to forecast and try and predict. And inflation— so if inflation goes up, or even if our inflation expectations rise, we think inflation's going to go up, that just means that money out in the future is less valuable to me, right? So I, as an investor lending to the UK government, I need a higher yield to compensate me for the fact that inflation's going up and my money is going to be worth less when you pay me back the loan. Okay, so the 30-year bond yield right now is spiking. It's gone up, it's actually trading at 5— above 5.4% now, the highest this century. And, you know, there's, there's a few reasons we're going to go into But actually, just today, technically, we've kind of broken out above the 2023 high. That's what's happened this week, basically. The 2023 high, which was just a touch above the Liz Truss high in 2022. We've basically broken that ceiling. And this has just led to a shot higher.

Yeah, so, so break that down for me in terms of these reasons then. So I'm assuming there's the Fed, there's a bit of Trump. There's a bit of government spending plans.

Right. And I maybe just— sorry, I didn't answer your counterintuitive point. So the Bank of England cut interest rates, right? We are expecting interest rate cuts. We'll talk about how many, because that's kind of playing into what's happening. But ultimately, normally when interest rates come down, yields come down. But here's the 30-year yield spiking to the upside. So that's where your contradiction— this theory is not being seen in markets here. What's happening is kind of going against theory a little bit. So the short end— yeah, go on.

Equally, would the pound not normally appreciate if interest rate expectations are moving higher, i.e., lesser cuts?

Yes, but sometimes, yes. Not this time. It depends why. Yields are going up. That, that then everything hinges on that in terms of how markets react, and we're going to get into it. But right now, because interest rates are not going up, the Bank of England is not hiking rates. In fact, they've cut rates, and we are expecting more cuts in 2025, fewer than we had thought. But look, interest rates are not going up, so that kind of anchors the short end of the curve, right? The short duration yields aren't going up, but the long end is going up. So actually, this is what we call a curve steepener. If you think about that chart where you're plotting all of the yields out across the different durations, if the long end's going up and the short end's not, the curve is steepening. Okay, so you might read about that, go and Google it. What's the steepening yield curve and all the rest of it? But look, why is it happening is, is the key question. And then, right, because of those reasons, why are markets behaving in the way they are? So it's really because of inflation expectations, number one. Okay, I'd say this is the most powerful. Now in the UK, we've got our own set of factors that are leading people to think inflation's going to rise here, or at the very least it's not going to go down. And inflation's still at whatever it is. I can't— I haven't checked for a while— 2.6%, I think. So this It's still not— in fact, it's gone back up in the last couple of months. So it's still above the Bank of England's 2% target, right? And it may well go back up. We've got our own reasons for that. I'll talk about those in a sec. But then more broadly, Trump is coming, and obviously that's the US. But Trump, one of his policies is tariffs, right? And if we start getting into a tariff war, Again, that's maybe inflationary not just for the US, but that could be inflationary for the planet, right? So inflation, Trump broadly, but then in the UK we've got policies, and there's two I'd perhaps refer to. So, and this is based off the budget that the Labour government rolled out in whenever it was, October last year, okay? And they made some huge changes for businesses. Now, number one, they raised the National Insurance tax, if you like, that businesses have to pay. And that's a percentage that you pay, a percentage of your employees' salaries. So costs of running businesses go up, right? What happens? Well, businesses tend to not like to have to reduce their profits. They don't want the margin to get squeezed because the government, in their wisdom, have decided to increase my tax. So you know what, I'm going to increase the prices of my end product. So I'm going to increase the product and the— or the service that I'm providing. So price is going up to avoid margin compression, right? That's inflationary. The other one is they're raising the minimum wage, so again, labor costs might go up, all right? And if wages are going up, this is inflationary. And again, back to the businesses got to pay these wages. Not only the wages going up, the tax on those wages are going up. So there's, there's a risk here that we might— and I'm going to use a word that is like the— it's a bit like Voldemort, you shouldn't say it, right? Shouldn't. And that's the word stagflation. And this is the worst economic scenario you can possibly have. This is where inflation's too high but growth is too low. So you've got prices rising in a weak economy, that's a disaster. Because prices going up, people can afford less, consumption gets damaged, the economy is already weak, so it makes the economy even weaker, and you're in this kind of vicious cycle. Okay, so this stagflation risk in the UK, because in October and November GDP figures for those two single months were negative. So right now we have negative GDP with rising inflation, and the thought is the Bank of England aren't going to be able to cut rates as much as we were hoping in this year, 2025. If— and so the long end of the curve's shooting up. And the final point is about supply of bonds. So you think about anything, the supply of anything dictates its price, right? We're expecting an increase in supply of new government bond issuance in 2025. Two reasons: still a hangover from COVID where we've got a huge amount of debt and a huge deficit that's got to be funded by more borrowing. And then Labour have stepped up and said, we want to spend more. Yeah, fine, we're going to fund it by increased taxes, but we're going to spend more. This might widen the deficit. We're going to have to borrow more. So more issuance means more supply, which drives prices down. And as we know with bonds, if prices go down, the yields go up. So you've got a whole cocktail of factors here that are all super positive for long-duration bond yields. We've had this trend in place for 3 months. It's just accelerated, and it's just taken out the 1998 high, which now makes for great headlines.

Can I, can I put a little sprinkle on your cocktail? And that, that being, is there also a little bit of political edge that's helping just, just fire this up a little bit more? Because I remember when Labour pre-election, um, Rachel Reeves is very much positioning herself as portraying Labour as the party of financial discipline, attracting international investment, bolstering growth. A lot of those things, all of those things you're saying isn't, uh, happening in combination. You've got the incoming US administration, which seems to be at the moment a co-presidential, uh, uh, duo of Elon Musk is president with Donald Trump. And he's also firing shots, which I think intelligently, strategically, he knows of the UK's uh, situation at present. And so he's got leverage on that front. So do you— is that also in investors' minds playing into this amongst those other things that you're mentioning?

The political one's a tricky one. I, I'd say that that cocktail I just described, that is plenty enough kind of factors, right, to be driving these market moves. I think the Trump, and more specifically the Musk kind of sudden interest in UK politics, um, trying to undermine the Labour government. I think, of course, Labour is a left— I mean, you'd say the Labour government in the UK is center-left. Um, you know, Musk and Trump, they're center-right. Okay, and so you could say that— and, and Musk is, you know, don't forget he's heading up this, um, new efficiency drive, right? His doge department where he's going to be cutting costs. You know, all, all, all governments have got too much debt because of COVID right? And it's not sustainable. I talked about this in our last episode. And ultimately, you know, I think Musk is now trying to kind of, um, I, I would guess preach that philosophy beyond the borders of the United States. And I would say that Labour, yeah, from his point of view, I guess the left-leaning, they're not, you know, they spend. And there's the free speech angle, which also Musk is a great advocate of. And so there's a natural clash of opinions between Musk and Labour. What's happened though is Musk has got this platform now, which is monstrous in size and influence. And he started to, I guess, take confidence from what has happened over the US election result, and he feels like he's now in a position of where he can voice opinion and, and change the kind of conversation in other countries now as well.

I wonder, isn't one of the gigafactories in Berlin, in Germany?

Yeah.

So if he can shift the political leaning further to the right— I think he's appearing on a podcast with the leader of the Alternative for Germany who, which the broader coalition in Germany have said are classified as far right and have not been endorsed by anyone inside the US administration to be, other than Musk, who's appearing on their podcast show. I wonder strategically, obviously, if he gets his way and better control and influence within Germany for that reason, of which manufacturing his cars, but then also in the UK, man, in Europe, much as in the US, It's interesting how I wonder if it was Taiwan and China taking Taiwan, would Musk be as interested as he is in some of these Western, uh, political—

he's definitely talking his own book. I mean, you're right with the German example. It's interesting, like the far right, you would assume would be more in line with the idea of putting tariffs on Chinese imports. So You know, the Chinese EV kind of takeover might get halted or at least slowed by tariffs. And then Germany don't want to have tariffs slapped on them by Trump, right? So if they can get in the good books of Musk, who basically— I don't know how far you want to go with this— is controlling Trump, then that could be really good for Germany with regards to German-US tariffs. So look, he's got— he's leveraged himself into a very interesting position, and he's, he's kind of maximizing the value of that.

All right, well, look, I always land myself in trouble talking politics and Musk, so let me go back to the original story. So one thing is, um, there isn't, let's call it, a hard ceiling for yields. I mean, they can just keep going.

Yep.

But that's not true though. You mentioned though in previous episodes, from a behavioral point of view We have broken through those levels, but in previous instances, we get to these levels, and surely at a 30-year yield at such an attractive level, doesn't that become a buying opportunity at that point?

Right. So, so what you're saying is there's an increase in demand to buy these bonds if the yield, the interest you get from that investment, goes up. It becomes more attractive from an investor's point of view, right? As long as you're confident the borrower isn't going to go bankrupt. Okay, now this is the UK government. Are they going to go bankrupt this year, 2025? No. Are they going to go bankrupt 2026? No. 2027? No. What about 2054? I don't know. One of the, one of the things here is debt levels are trending higher. One of the concerns is debt is not— these, these levels, they're not sustainable, right? So if you get a Labour government coming in who wants to spend more, that's a problem if you're worried about debt sustainability. But back to the real point, am I happy to buy a UK 30-year government bond at 5.4%? Yeah. Because that's a great yield, thanks, and they're not going to go bankrupt. And even if I think they are in XXX number years' time, I can sell that bond way before then, right? So it's a great yield. So this is bad news for stocks because if you're getting such a great yield off a really safe asset, well then why would I buy FTSE 250 mid-cap stocks, right? Well, I wouldn't. Well, that's why they're selling off. They've had their worst 2 days of a sell-off for, I think it's for 15 months or something, right? So people are selling stocks to buy these bonds at really attractive yields. This pound, the pound is getting hammered. Now that's a really interesting one because the textbook would say, well, hang on, if yields are going up, that's good for the pound. It should attract an inflow of money into the UK where international investors are coming in, swapping their dollars for sterling, buying UK government bonds to benefit from these really high yields. That ain't happening, right? No. So the reason is that yields are going up for bad reasons. They're going up because of stagflation risk, because of inflation risk. It's not like the US. The US, we've got inflation risk, but growth is on fire, right? Great, I'm going to buy US bonds. That's why the dollar's appreciating. In the UK, you've got inflation risk plus recession. That's the big difference between the two. And that's why investors are looking at this situation in the UK and they're going, eesh, I'm not sure I want to touch that.

More positive then for US equities 2025?

Um, uh, what, versus UK equities?

Well, come on, I've got to pump my call here for a nice positive 2025. Come on, North America is where it's at, Piers.

Yeah, but I'm still, I'm still of the opinion the Mag Seven aren't going to do the heavy lifting in 2025. If the S&P wants to go up, I think it's got to be a broad-based rally and not, but look, I might be, I've been wrong, that the Mag Seven have lifted that market for 2 years in a row, Right.

Have you not seen Zuckerberg's new clip he's just put out in the last 24 hours? He is sucking from the teat of Donald Trump and aligning himself. Him and Musk were going to have a cage fight 12 months ago. Now they're besties. This, uh, Trump, you know, let's go, Mach 7, bit more juice left.

I, I, I'm, I'm still cautious. Look, I think bond yields are very notably going up. And look, don't forget that in the end, who— why are bond yields important? It's the cost of borrowing, right? So if you're a person, an individual, if you've got a credit card, if you've got a mortgage, more importantly, if you've got— if you run a company and you're— you've got an overdraft facility, or you've got a short-term 5-year loan, or whatever it is, right? The cost of money is going up. And it's the rate of change that's right now alarming this week. If the speed of these yields going up, if that speed continues, like, even for a few weeks, then you could be looking at 6% yields here. And then people are going to start to really panic that, hang on, this isn't sustainable. The cost of borrowing at that level when the government's got so much debt, that's not going to— something's got to give. And so it's the rate at which we're going up at the moment that's grabbing attention and causing these headlines.

Your experience then as a trader, would you be expecting though, before 6%, for example, there'd be some kind of communication from the Bank of England to settle things?

So there are levers they can pull to deal with this. And it's been done before. And in fact, they did it during the Liz Truss debacle in 2022. The Bank of England stepped in and bought long-duration government bonds, bought them. So that's buying them, driving the price up, driving the yields down. That's one example. Another one, I won't go into the details, but Operation Twist, um, Ben Bernanke, chairman of the Fed, uh, 20 2012, do I want to say? I got a feeling it was 2012. Well, it was post-crisis. It was 2012, I think it was. And basically, again, he wanted to end— the long end of the yield curve was too high relative to the short end. He wanted to engineer that back, and so he sold short-term bonds. So the Fed owned government bonds through their QE program. He was selling the short-term bonds and with the money was buying long-term. So he wasn't changing the money supply. It's not quantitative easing. The money supply stays fixed. It's just you're swapping out the makeup of the Fed's balance sheet. So that had the effect of flattening the curve. So that is another tool that could be used. But again, if we're using these tools, then something's wrong.

This is my counterargument to the apocalypse scenario you mentioned, which is the there's too much debt, it's unsustainable. TWIST didn't exist, TARP didn't exist, QE didn't exist. What's to say that there's not another 5 acronyms that come out the woodwork over the next 30 years?

But how many rabbits are in the hat? Are there any left in there? I don't know.

By the way, Bernanke, 2006, 2014.

Okay. But Operation Twist was 2012. Well, you can fact-check that, but I'm pretty sure.

Yeah. Cool. All right. Well, look, we will leave it there. So overall summary though, quick take is you're not panicked at this point.

No, no, no.

Definitely keeping half an eye on.

Keeping a full eye on it. And if the rate of increase of yields continues, which it almost certainly won't because it's the speed at the moment, it's unsustainable. But let's just say it actually did. By the end of January, if we're at 6% yields, then that, that's the single only thing anybody's going to be talking about. Forget everything else. Our markets will be entirely driven by that factor. But it probably won't happen. This is a breakout spike. Things will probably settle, but settle still at a high level. And so look, we're not out of the woods and it needs to be monitored.

So a summer general election.

That's right.

You heard it here first, folks. Come on, Elon, make it happen. No, full disclosure, I did vote Labour. All right, we'll end it there. Thanks very much, Piers. See you next week.

Catch you later.