The next few months will be a major test for financial markets across the globe as it digests the tariff news emerging from the US.
Usually, UK government bonds would provide a safe haven, but these are not usual times.
In the immediate aftermath of US President Donald Trump’s announcement, gilts have been down, as they anticipated rate cuts, and then up as they anticipated inflation.
it’s important to remember that higher bond yields present opportunities as well as risks
Gilts had already seen a lot of volatility in 2025. After a precarious start to the year, when UK yields flirted with multi-year highs, the bond market has also had to digest the Spring Statement, turmoil abroad and stubborn inflation.
The international situation is tough to disentangle. Tariffs have been on and then off again.
While the UK economy has been spared the worst level of tariffs, it cannot escape the knock-on effects of trading problems across the world.
This might raise inflation because goods become more expensive, or lower it because it triggers a recession.
This uncertainty is evident in the bond market, which is giving indications of not being able to make up its mind.
The domestic picture is also difficult to unravel. There is little argument that the UK economy is on a sticky wicket. There are multiple spending pressures, while growth is elusive and borrowing is already maxed out.
As a result, it is clear that UK bond sales are likely to be higher than was expected in last year’s Budget.
A panel of experts polled for the Financial Times suggested there could be £310bn in issuance next year, a level only surpassed during Covid-19. This is around £10bn higher than the level set in the October Budget.
This could push yields higher.
Rising inflation
Equally, inflation has remained stubbornly high, hitting 3 per cent in January and dipping slightly to 2.8 per cent in February, but the Bank of England is still forecasting a peak of 3.7 per cent later in the year, with rising costs for energy, water, broadband and council tax. This does not factor in the impact of a global tariff war.
This is giving the BoE pause for thought on interest rate cuts. In its latest Monetary Policy Committee minutes, the Bank said: “A gradual and careful approach to the further withdrawal of monetary policy restraint is appropriate . . . Monetary policy will need to continue to remain restrictive for sufficiently long until the risks to inflation returning sustainably to the 2 per cent target in the medium term have dissipated further.”
The Bank will need to judge the impact of the rise in employers’ national insurance, weighing the potential hit to employment with a possible rise in prices. This could slow rate rises and keep gilt yields higher for longer.
The continued pressures on the government purse could also create upward pressure on yields.
The UK’s promised hike in defence spending – to 2.5 per cent of GDP from 2.3 per cent – needs to come from somewhere.
The government has little room to raise taxes, cut spending or raise borrowing. This means the UK’s finances are likely to continue to bump up against their limits.
Yet there are more optimistic signs.
Most economists continue to forecast further rate cuts later this year. Capital Economics, for example, still expects three further interest rate cuts this year and one in early 2026, taking interest rates down to 3.5 per cent.
Tax revenues are rising: HM Revenue & Customs reported tax and NIC receipts for April 2024 to February 2025 at £787.2bn, £25.5bn higher than the same period last year.
VAT has been given a lift by rising inflation, while the freeze on income tax bands has helped inflate income tax revenues.
Unsurprisingly, this environment brings divergent views from investment managers. At one end is RBC BlueBay, where the fixed income team says: “Stagflation fears are a reason to be wary on UK assets and the pound, and we would look to short 10-year gilts close to 4.40 per cent.”
Eva Sun-Wai, fund manager on the M&G Global Macro Bond fund, says: “On a cross-market basis, gilts seem to be a reasonable place to take some duration risk.
“We feel like a lot of the bad news is priced in. We think the Bank of England will probably need to start acknowledging some of the weaker data and price more dovishness into policy rates. We like front and longer-dated gilts.”
She is marginally less positive on the currency, given a strong recent run.
However, fellow M&G manager Richard Woolnough, who manages the M&G Optimal Income fund, sounds a note of caution. He says the seeds of the current weakness may have been sown under the last government, which may have called last year’s election when it realised how difficult this period would be for the UK economy.
“What we’ve had the last six months isn’t down to this administration – it can’t be. It’s too short, and economies work with a lag. We have got a weak economy. But what can the new administration do? Will they make it even weaker? Will it recover and go for growth?” He says this question remains unanswered.
A tricky dilemma
Bryn Jones, manager of the Rathbone Ethical Bond fund, says: “We’re not out of the woods yet inflation-wise. The Bank of England has warned that it expects UK inflation to rise quite a bit by the autumn largely because of higher energy and transport prices before falling back once more.
“This tempered initial optimism on potential rate cuts after two BoE policy-setters voted for a half-percentage-point cut when the Bank made a 0.25 per cent reduction in early February.
“The BoE’s inflation warning was part of the pretty grim forecasts that accompanied that rate cut. It slashed this year’s GDP growth forecast from 1.5 per cent to just 0.75 per cent, saying that the Budget increase in employers’ national insurance contributions would hit both jobs and prices more than it had initially expected.
“Rising inflation alongside super-sluggish growth would represent a tricky dilemma for UK policymakers.”
He says bouts of market volatility are always unsettling. “But it’s important to remember that higher bond yields present opportunities as well as risks. Generous yields offer the prospect of durable, long-term income streams. And with yields relatively high, it reduces the price falls that accompany any further increase in yields.”
Disentangling these divergent views is tough. Gilts yields are high relative to European and US bonds, and the gloom about the UK’s financial position may be overdone.
However, the US tariff situation is a wild card. While gilts have an important role as a diversifier and source of income, investors need to be braced for volatility in the months ahead.
Darius McDermott is managing director FundCalibre and Chelsea Financial Services
