Bond markets continue to stabilize, but risks remain

The market is calmer on Thursday, and UK bond yields have stabilized after the sharp sell off earlier this week, although it’s worth noting that there has been no recovery in UK bonds and yields remain at elevated levels.

Quiet US markets ease selling pressure on UK bonds

The halt to the UK bond sell off could be down to multiple factors. Some have wondered about official intervention; however, we think that this is unlikely.  Financial markets are quiet on Thursday, US equity markets are closed, and the Treasury market has shortened hours due to President Carter’s funeral. Since UK yields have been moving higher along with US yields, the fact that US bond markets are quiet could spill over to the UK. However, this could be a short reprieve.

BOE rate cut hopes increase

The market has also boosted expectations for interest rate cuts from the Bank of England. On Wednesday, the market expected interest rates to end 2025 at 4.21%, this has fallen to 4.18% on Thursday, also, expectations for a rate cut in February have been boosted to 74%, this had been 68% yesterday. The volatility in interest rate expectations is one of the side effects from the bond market sell of. It also suggests two things: 1, the outlook for UK inflation is vital for the UK bond market. 2, The market could be pricing in weaker growth on the back of the spike in bond yields in the UK, which may require additional BOE support.

Shop price inflation falls at fastest rate for three years

There was also ‘good’ news on inflation in the UK. The BRC shop price index for December fell by 1% YoY, which was a larger than expected, and is the largest decline for 3 years. This is a sign of stress for the UK’s retailers, which could hurt growth down the line. Added to this, the December report on jobs from the Recruitment & Employment Federation, KPMG and S&P Global, signaled further loosening in the jobs market, with permanent and temporary placements all lower. Data like this could sway the BOE into a faster pace of rate cuts. Quantitative easing also cannot be ruled out if we see a sustained sell off in bonds. A prolonged bond market crisis in the UK, could see the BOE follow the BOJ into long term purchasers of sovereign bonds.

Weak data, quiet US markets and hopes of BOE rate cuts are working to stabilize the UK bond market on Thursday. However, we think that the UK bond market will suffer more frequent bouts of volatility this year, as the UK remains firmly in the bond vigilante’s sights. A weak economic outlook, nervous investors who will be sensitive to news headlines and data releases and also the failure of the current government to firmly lay out their plans to get public spending under control, get people back to work, and boost growth without taxing the UK economy further, are all weak links for the UK bond market.

Will the UK face a credit rating downgrade?

Key risks include credit rating downgrades on the back of surging bond yields and a weaker growth outlook. Although the credit rating agencies have been quiet so far, they did speak out after the Budget. Back then, Moody’s said that Rachel Reeve’s plans to extend borrowing and the rewriting of the UK’s fiscal rules posed additional challenges to repair the UK’s finances, and they also said that they were concerned about the limited buffer Reeves had left herself. Both issues have been exacerbated by the recent bond market sell off in recent weeks, which could trigger a ratings warning for the UK in the coming weeks.

In the short term, next week’s CPI data is also a risk to the UK bond market. If CPI for December surprises to the upside, it could trigger more fears about stagflation and reduce expectations for BOE rate cuts, which could trigger another sell off in UK bonds.

GBP underperforms South African Rand and Argentine Peso

Signals from the FX market also suggest that concerns about the UK’s fiscal position have not been put to bed. GBP/USD has climbed back above $1.23 on Thursday afternoon; however, it continues to look vulnerable and is lower by 1.23% so far this year. This means that the pound is the worst performing currency in the G10 FX space. It is also the weakest currency out of the expanded majors and is weaker than the Hungarian forint, the Peruvian Sol, the Argentine peso and the South African rand so far in 2025.