There has been a great deal of discussion about what recent moves in UK gilts mean for future spending and tax decisions. This column argues that it is difficult to find observable economic factors that explain why UK yields have broadly tracked US yields since the US election, and so contagion might account for a part of the rise. The evidence that fiscal sustainability fears have played an important role in recent yield moves is not clear-cut. Nevertheless, conventional arithmetic suggests significant fiscal challenges, and so the author recommends a set of further measures in order to make a future crisis less likely.
Recent moves in UK gilts have attracted much media attention, with a great deal of discussion about what this means for future spending and tax decisions. Much of the commentary has linked the rise in UK long-term interest rates in a mechanical fashion to the rise in US yields and has tended to imply that UK-specific factors have not been particularly relevant. I am less sure.
Table 1 shows the rise in 20-year yields in the US, the UK, and Germany between the recent US election on 5 November 2024 and the recent peak in global yields on 14 January 2025. Importantly, note that the effects of the UK budget on 30 October should have been fully priced in before 5 November.
Table 1 Change in 20-year yields since the US election
Source: Bloomberg.
Note: Change in 20-year benchmark government yields between the respective closes on 5 November 2024 and 14 January 2025.
A notable feature of these recent moves is the fact that UK gilt yields broadly tracked the rise in US Treasury yields, while German yields rose by rather less. So those who have asserted that the rise in UK yields just reflects global developments have some explaining to do. I attempt to shed some light on the developments shown in Table 1 by first looking at some of the reasons that have been offered for the rise in US interest rates and examining the relevance of each of these factors for UK and German interest rates.
Possible explanations for the rise in us interest rates
Changes in the outlook for monetary policy
In the US, there has been an ongoing re-evaluation of the appropriate stance by the Federal Reserve in recent months. By way of example, in September 2024, the median projection of Federal Open Market Committee (FOMC) members implied a 100 basis point decrease in the federal funds rate for 2025; by December, this had been cut to 50 basis points. Indeed, the minutes from the Federal Reserve’s December 2024 meeting revealed that “almost all” policymakers perceived an increased risk of above-target inflation, in part due to the “likely effects of potential changes in trade and immigration policy”. In addition, the Federal Reserve had originally cut rates in September to provide some insurance against downside risks to growth which are yet to materialise.
Of course, any impact of such changes in US policies on UK or German inflation should be much smaller. Furthermore, forecasts for UK and German growth in 2024 and 2025 have been coming down in recent weeks. Indeed, in the UK, one member of the Monetary Policy Committee (Taylor 2025) has recently spoken of the need for more interest rate cuts than the markets are pricing in. Table 2 shows that, indeed, the move in two-year yields in the UK and Germany over the relevant period has been rather smaller than that in the US. So, it is unlikely that changes in monetary policy expectations can explain the pattern of moves seen in Table 1.
Table 2 Change in two-year yields since the US election
Source: Bloomberg.
Note: Change in two-year benchmark government yields between the respective closes on 5 November 2024 and 14 January 2025.
Changes in longer-term inflationary pressures
Some have argued that the fears relating to the inflationary policies of President Trump have not only affected the outlook for monetary policy but also had an effect on the term premium, perhaps because the incoming administration might undermine the degree to which the Federal Reserve is independent (e.g. Ritchie and Mackenzie 2025). It is, though, notable that, hitherto, breakeven inflation has actually fallen in the UK since the US election (see Table 3) despite a modest uptick in the US and Germany. So, the relative moves in breakeven inflation can explain neither why UK yields have risen faster than in Germany nor why UK and US yields rose by similar amounts.
Table 3 Change in 20-year breakeven inflation since the US election
Source: Bloomberg.
Note: Change in 20-year generic breakeven inflation between the respective closes on 5 November 2024 and 14 January 2025. I have reported the change in the ten-year breakeven rate in Germany because of data availability considerations.
Changes in the foreign official demand for US treasuries
In a fascinating Vox column, Ahmed and Rebucci (2025) argue that one reason that longer-term US interest rates have risen since September 2024 despite the cut in short-term US interest rates of 100 basis points is that there has been a sharp decline in foreign official dollar reserves. They point to post-election selling of US Treasuries “at an accelerated pace” and suggest that foreign officials are reallocating towards gold as a reserve asset. As I am not aware of any meaningful change in the allocation to UK gilts or German bunds by foreign reserve managers, this factor too cannot explain the fact that UK 20-year gilt yields have risen almost in line with Treasuries but by more than bunds since the election.
Concerns about fiscal sustainability in the US
For some time, the famous investor Paul Tudor Jones has been warning that the poor US fiscal situation could, at some point, precipitate a bond market crisis (e.g. Tett 2024). A starting point for being worried is that the Congressional Budget Office estimates a current budget deficit of 6.6% of GDP (CBO 2025), which is high for an economy seen to be close to full employment.
Recall that real interest rates, r, were low in the US over the 2012-2021 period, specifically, the real 30-year rate ranged between a low of around -0.75% in March 2020 and a peak of around 1.7% achieved during 2013-14. As Blanchard (2022) emphasises, this implied that because r was lower than plausible estimates of the real growth rate of the economy, g, one could expect, other things being equal, the debt ratio to reduce over time. This possibly accounts for the apparent disappearance of ‘bond vigilantes’ in the context of US Treasuries. The worrying fact today is that in the US the current value of r (around 2.5%) is now higher than the CBO’s assumption for the long-term growth rate of 1.8%. With r>g, fiscal sustainability requires that the US runs a primary surplus. But the primary deficit is currently 3.6% of GDP and is projected to still be 2.1% of GDP in 2035.
But, for now, the rise in US yields in recent weeks does not appear to reflect fiscal sustainability concerns as the US dollar has been appreciating at the same time as the rise in US real yields, and so fiscal worries relating to the US cannot explain the rise in UK and German yields either (though I consider the independent role of fiscal worries about the UK below). I conjecture that one reason the US bond market is not worrying more is that it is waiting to see if Elon Musk will help cut government spending and whether the new Treasury secretary, Scott Bessent, will make some progress towards his stated goal of a deficit of 3% of GDP.
Sometimes, I hear people say that the ‘exorbitant privilege’ associated with providing the safe global asset and reserve currency supplier implies that the US need not worry about fiscal sustainability. This has always struck me as a rather extreme view, and it is interesting that Choi et al. (2024) suggest that the privilege is estimated to increase the maximal sustainable level of debt by 22% of GDP and so it merely postpones the day of reckoning. Of course, my calculations depending on (r-g) and the primary balance already incorporate the benefits associated with the ‘exorbitant privilege’.
The role of contagion
We have, so far, struggled to find observable economic factors that might plausibly explain why UK yields appear to have broadly tracked the rise in US interest rates. Of course, it was similarly difficult to explain the relative uniformity of stock price declines in all major markets during the 1987 stock market crash, and therefore Mervyn King and I argued that rational investors might then have attempted to infer unobserved information from the price changes in other markets (King and Wadhwani 1990). It is therefore possible that one reason UK gilt yields rose recently is that investors assumed that the relatively large rise in US yields contained ‘private unobservable’ information that was also relevant to the UK, and we labelled such a phenomenon as “contagion”. But there is no obvious reason as to why investors would not feel similarly about German bunds. So, as German 20-year yields have risen rather less than those in the UK (since the US election), it would then appear that contagion could only ‘explain’ a part of the rise in UK yields.
So, if we cannot find common factors linking the comparable rise in yield rises in the US and the UK since the election, can we find idiosyncratic, UK-specific factors that coincidentally drove up longer-term interest rates in Britain? It is to that subject I turn next.
UK-specific factors that might have driven up gilt yields over the recent period
The UK Budget
Many popular accounts of the recent rise in UK interest rates point to the Budget statement on 30 October, when the extra borrowing was seen by the Office for Budget Responsibility as leading to greater inflationary pressure that required the Bank of England to increase interest rates (OBR 2024). But, as mentioned above already, it is rather implausible that the UK budget can explain what happened to UK yields after the US election, which was not until 5 November and as many as four working days after the Budget statement.
Fiscal sustainability considerations in the UK
UK real rates were remarkably low during the 2012-2021 period and so r was usually comfortably below g. Specifically, the high in 20-year real rates over this period was less than 0.5%, while the low was nearly -3%!! This is an environment when bond vigilantes have little to do. But the 20-year real yield on 14 January 2025 was around 2.06%, which is higher than the OBR’s long-term growth assumption of around 1.7%. In this new environment, the UK needs to run a primary surplus. The last set of projections published by the OBR did suggest that the current primary deficit of 1.6% of GDP would shrink and move into balance by 2026-27, followed by a surplus in 2029-30. So, if one believes these projections, then the UK fiscal situation is within touching distance of being sustainable on a rule of thumb based on comparing (r-g) with the primary balance.
Of course, this implies that the UK compares favourably with the US in the fiscal sustainability stakes as the US is set to run primary deficits as far as the eye can see. On the other hand, the UK compares unfavourably with Germany, which has the advantage of the long-term real interest rate being considerably lower – around 0.7% on a 25-year inflation-linked security. The estimated debt-to-GDP ratio in Germany is rather lower than in the UK (63% in Germany in 2024 versus 98.4% in the UK) and the European Commission projects modestly declining deficits in the coming years (European Commission 2024). One interpretation of the fact that US and UK yields have risen by more than those in Germany since the US election is that the markets are beginning to differentiate more on the basis of fiscal sustainability.
On the other hand, notwithstanding some commentary about sterling weakness coinciding with the rise in gilt yields during January (e.g. Dalio quoted by the Financial Times 2025), it is notable that the UK currency was almost unchanged versus the euro between the US election and 14 January (an exchange rate at the close for the euro versus the British pound of 0.838 on 5 November versus 0.8438 on 14 January). Of course, sterling has weakened against the US dollar over the same period, but this appears to be a story of broad US dollar strength rather than general UK currency weakness.
So, it is not obvious that the move up in gilt yields for the whole period since the US election is explicable by fiscal sustainability concerns, though there are some preliminary tentative reasons to begin to worry on this score (for example, the outperformance by Germany and sterling weakness in January). Moreover, there are other reasons to be more concerned about the UK’s fiscal situation than the analysis above implies.
Using nominal interest rates implies that a larger primary surplus is required
If we use the nominal interest rate instead, the 20-year gilt yield on 14 January was 5.39%. If we assume that the Bank of England keeps inflation at target over the medium term, then the OBR’s assumption for nominal GDP growth would be 3.7% per annum, which suggests a need for a larger primary surplus than implied by the analysis using real interest rates above. Of course, this is just implied by the existence of a significant ‘inflation risk premium’ in the UK – a phenomenon that was recently discussed, for example, in Wadhwani (2024) and Giles (2024).
The OBR’s projections of an upcoming primary surplus are not believed
There is widespread scepticism about the OBR’s projections of a primary balance by 2026-27. For example, Monks (2025) points to the following:
- The OBR’s assumptions about GDP growth seem too high and are inconsistent with business survey evidence and those published by most other forecasters.
- UK defence spending needs to rise significantly in the wake of the election of President Trump.
- The assumption that fuel duty will rise might, as in recent prior years, turn out to be too optimistic
- The public spending assumptions to 2029-30 are quite tight for the unprotected departments and might be difficult to deliver.
Moreover, some market participants point to the following:
- The OBR has had a historical tendency to be too optimistic with regard to its fiscal projections
- Over the last 30 years, a primary surplus in the UK has tended to be the exception
Some tentative conclusions and policy implications
To summarise:
- None of the observable economic factors that might have moved US Treasury yields in recent weeks can account for the increase in UK interest rates.
- So, in order to explain this rise in longer-term gilt yields, we have to either fall back on an explanation based on contagion, or, perhaps, initial concerns relating to fiscal sustainability, though the evidence relating to the latter factor is far from clear-cut.
Given these conclusions relating to the why of gilt yield movements, what is it that policymakers should do?
With regard to contagion, this phenomenon reflects a ‘shoot first, ask questions later’ attitude in markets. Back after the October 1987 crash, once questions were asked and it was realised that a part of the price falls were due to ‘portfolio insurance’, markets did recover at a differential pace more consistent with the underlying fundamentals. Analogously, we should expect any ‘overreaction’ in the gilts market to fade over time.
But, there are scenarios in which US yields could rise significantly – for example, if the budget deficit is not cut and perhaps expands. If the bond vigilantes are active in the US market, they are likely to also look at other countries where fiscal sustainability is questioned. Recent gilt yield moves would look like just a minor tremor relative to what we might see in a full-blown crisis.
In that regard, it is appropriate that the UK government have described their fiscal rules as “non-negotiable” and have signalled that spending will be cut to ensure that the rules will be met. I suggest seven more things that the authorities should do:
- Do not restrict their flexibility with respect to actions that might be necessary, so do not rule out tax rises; instead, just say that you will do “what it takes”.
- If tax rises become necessary, try to use those that hurt growth as little as possible – for example, a switch to land taxes at the expense of those levied on labour and capital might actually promote growth (e.g. Goodhart et al. 2022). In this regard, it might also make sense to substitute some tax rises announced at the last Budget that were perceived as being unfriendly to growth. This is especially true of tax rises that made it more difficult for the Bank of England to cut interest rates.
- When considering fiscal sustainability, investors confront Knightian uncertainty when it comes to estimating the appropriate rate of long-term growth. So, narratives matter. It would be helpful if we heard something genuinely new and dramatic from the government about how they are going to be growth-friendly, especially if it deals with something that is perceived as being difficult to do in a political sense.
- It is important to build in sufficient ‘wiggle room’ relative to the fiscal rules, otherwise we risk too many fiscal events with the associated uncertainty that is unhelpful.
- In terms of communication, the government should try to not link UK yields to US yields. If the UK government is able to put its fiscal house in order, it will want the markets to differentiate between the two countries.
- Take measures to reduce the debt interest bill directly – for example, I have previously proposed allowing the Bank of England to set its own inflation target (Wadhwani 2024). A key point to make here is that the markets confront Knightian uncertainty with regards to what future UK governments will look like in, say, 15 years. Anything that makes it more difficult to amend the inflation target would be perceived as a good thing by markets. I also suggested that the proportion of issuance taking the form of index-linked debt be increased – this would be seen as a signal that the UK government believes that the inflation target will be hit. Note that these measures would reduce the ‘inflation risk premium’ that the UK government currently pays unnecessarily, and, as I showed above, would make the fiscal arithmetic look less forbidding.
- The Bank of England also has an important role to play. It should remind markets that upward moves in gilt yields that are not warranted tighten financial conditions and therefore imply that short-term interest rates can be lower. It is also important that the quantitative tightening programme is not always on autopilot. Unwarranted moves in gilt yields should be perceived as leading to an adjustment in the pace of gilt sales. Moreover, fiscal tightening will slow the economy and, again, the Bank should make it clear that they will respond appropriately.
Overall, many of the suggestions above are designed to avoid destabilising moves in gilt yields by ensuring that markets have a better understanding of how the authorities might respond.
Source : VOXeu
