Long bonds at risk from ongoing fiscal sustainability concerns

Long-term UK gilt yields are rising despite falling inflation expectations and BoE rate cuts. Explore how debt sustainability concerns and reduced demand for bonds are driving this unusual market shift.

Why are long-dated UK Gilt yields rising even as the Bank of England cuts interest rates?

​Long bonds at risk from ongoing fiscal sustainability concerns

Mike Bell, CFA, Interim Macro Investment Strategist at Elston Consulting

Something unusual has been happening recently. The market has moved over the last couple of years to price in more rate cuts from the Bank of England, leading to a decline in 2 year gilt yields. However, 30 year gilt yields (government borrowing costs) have continued to rise.

Interestingly, this rise in long dated bond yields isn’t down to rising inflation expectations. Market expectations for average inflation over the next 30 years have declined over the last couple of years. 

Instead, rising long term bond yields are being driven by concerns around the sustainability of government debt levels and a reduction in price insensitive demand for long dated bonds.

The financial crisis in 2008 led to a very significant increase in government debt to GDP levels. Despite years of “austerity” after the financial crisis, government debt to GDP levels didn’t decline. Then Covid led to another increase in government debt to GDP levels, as the furlough scheme supported the economy and prevented what would otherwise have likely turned into an economic depression. 

That has left government debt levels at historically elevated levels. To prevent debt levels from rising relative to GDP, nominal growth (GDP plus inflation) needs to be higher than borrowing costs + the primary fiscal deficit (the difference between the tax take and government spending, excluding interest payments). In very few of the major developed economies in the world is that currently the case, leaving government debt to income ratios on an unsustainable trajectory, if nothing changes.
And as populations age, government spending is only set to increase as pension and healthcare costs rise. This makes it very challenging, politically, to bring spending into line with taxes.

Price insensitive demand for long dated government bonds has also declined. One reason is the shift away from defined benefit pension schemes to defined contribution schemes, as well as fewer people buying annuities.

Another key reason is that for years, central banks bought government debt as part of their QE and yield curve control programmes, with the intention of lowering long dated bond yields. Now though central banks are no longer buying and are actually reducing the amount of government bonds that they hold, placing upward pressure on long term yields.

We fear that debt sustainability fears could continue to rise in the UK and other developed markets. Tax rises have already contributed to job cuts in the UK and raising taxes further could just weaken the growth outlook even more. Historically, recessions and the accompanying rate cuts have tended to benefit long dated government bonds. However, there is a risk that from these starting debt levels, a recession could simply further exacerbate concerns about long term debt sustainability by increasing unemployment benefit spending as GDP declines. Long dated government bonds might therefore not prove as reliable a source of diversification as they have in the past.

Ultimately, we think central banks will eventually have to step in and lower long-term bond yields. But it could take a bond market crisis before that happens and lowering long bond yields could weaken the currency if it requires more money printing from central banks.
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For these reasons, we prefer short dated government bonds, which tend to be more influenced by interest rate expectations, to long dated government bonds, where long term fiscal sustainability is more of a consideration. We also think alternative assets, such as gold, could prove a useful hedge against concerns around fiscal sustainability and the devaluation of fiat currencies.