The government’s short-term borrowing costs were on course to have their worst month since Liz Truss’s mini-Budget, though a pause in hostilities between the US and Iran briefly altered market expectations on Monday.
The two-year gilt yield jumped by eight basis points on Monday morning, reaching 1.1 per cent higher than before the conflict in the Middle East began. The 10-year gilt yield – a benchmark for government borrowing capacity – also reached its highest level since the global financial crisis.
Later on Monday, Donald Trump announced a five-day pause in US air strikes while diplomatic talks commenced, though Iranian officials denied the negotiations were taking place. UK bonds partially reversed earlier gains as markets reacted to the conflicting reports.
The conflict between the US, Israel and Iran has disrupted expectations that both the Bank of England and the US Federal Reserve would cut interest rates this year.
Movements point to four interest rate hikes
Market movements on Monday suggested traders were preparing for as many as four interest rate hikes over the next 12 months, driven by concerns that rising energy prices will fuel inflation. Nigel Green, chief executive of Devere Group, described the situation as “the early stage of a dangerous chain reaction,” noting that a spike in oil and gas prices is directly impacting inflation expectations.
Iran has so far refused to reopen the Strait of Hormuz, a crucial shipping lane for a fifth of the world’s oil and gas supply. The US President set the Iranian regime a 48-hour deadline to unblock the passage, threatening to destroy much of its energy network if they refused. Tehran responded by threatening to destroy infrastructure across the Middle East, potentially driving up global oil and gas prices.
Three weeks ago, the market anticipated two rate cuts in the UK this year. Analysts now suggest rates could be hiked four times by the end of 2026, with significant consequences for spending, the economy, and public finances, according to Russ Mould, investment director at AJ Bell. Pantheon Macroeconomics estimates the market rout has created a £7bn hole in the UK’s public finances.
Sell-off evokes memories of Truss crisis
The recent sell-off in UK bonds mirrored the turmoil following Liz Truss’s mini-Budget. That event, which included tax cuts and spending pledges during the 2022 energy shock, required Bank of England intervention to stabilize the market.
The Bank of England previously raised concerns about the increasing proportion of UK sovereign bonds held by risk-seeking foreign hedge funds. Changes in capital market regulation have led to increased reliance on these funds, as pension funds and insurance firms diversified their bond holdings.
Hedge funds have increasingly engaged in borrowing against small price fluctuations in the UK bond market to boost returns.
Frequently Asked Questions
What caused the initial spike in UK borrowing costs?
The initial spike was caused by concerns over the conflict between the US, Israel and Iran, and the potential for disruption to oil and gas supplies, leading to inflationary pressure.
What impact did Donald Trump’s announcement have on the markets?
Donald Trump’s announcement of a five-day pause in air strikes and the commencement of diplomatic talks led to a partial reversal of the gains made earlier in the day by UK bonds, as markets reacted to the changing situation.
How does the current situation compare to the crisis triggered by Liz Truss’s mini-Budget?
The sharp sell-off in UK bonds is comparable to the crisis sparked by Liz Truss’s mini-Budget, which also led to significant market volatility and required intervention to stabilize the market.
How will the ongoing geopolitical tensions ultimately impact the UK economy and household finances?
