The gilt shock: why Britain was worst hit by the global bond market sell-off

Given the current uncertainty, the Bank of England’s decision to hold interest rates at 3.75% last week was “the only one possible”, said Nils Pratley in The Guardian. “Policymakers are as clueless on the length of the war, and the cost of energy six weeks or six months from now, as stock market investors.” So why did the London bond market throw such a wobbly?

UK borrowing costs soared to their highest level since the 2008 financial crisis on the day after the Bank’s meeting, with the yield on benchmark 10-year gilts surging to 5%, “deepening a three-week long rout”, said the Financial Times. Two-year gilts – the part of the market most sensitive to interest-rate moves – were also pummelled.

Britain has been hit hardest in the global bond sell-off since the outbreak of war, because our dependency on imported energy means spiking oil and gas prices “quickly feed through to broader inflation”. When combined with flatlining growth and rising household borrowing costs, the risk of recession is plain.

‘The spectre of stagnation’

Perhaps last week’s turmoil was “a weird overreaction” to the Bank’s hawkish new tone, said Katie Martin in the same paper – rather than interest rate cuts this year, we are now contemplating hikes. But “the spectre of stagnation stalks the land”. The market has stabilised, but “in aggregate, more than £100 billion has been erased from the market value of UK government bonds in a matter of weeks”, said Stuart Fieldhouse on The Armchair Trader.

“UK rate expectations have been on a remarkable journey in barely a month,” said Chris Beauchamp at IG. “A full 100 basis points rise in rates is now expected for this year.” The bad news for consumers and business is compounded by the implications for the Government of “a fiscal squeeze”. If there’s further escalation in the Middle East, “this may be just the beginning of the crisis”.

The ‘Maradona Effect’

As data on demand weakness becomes evident, the Bank of England won’t want “to compound the damage with higher interest rates”, said Karen Ward of J.P. Morgan in the Financial Times. I suspect it is deploying the “Maradona Effect”, named after the footballing legend whose greatest skill was feinting. Conveying a very hawkish signal about the outlook for rates may obviate the need to actually raise them.

The Bank “faces an acute dilemma”, said Roger Bootle in The Telegraph. As we learnt in 2022, the issue at stake is what happens to inflation after the initial, oil-induced spike. The case for higher rates is to ward off “second-round effects” and stop inflation becoming embedded. “The art of central banking lies partly in not overreacting, but also in not taking action too late.”