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A rout in the gilt market deepened on Monday as traders bet the Bank of England would have to raise interest rates four times this year to counter surging energy prices.
The 10-year gilt yield climbed 0.11 percentage points on Monday morning to 5.1 per cent, keeping borrowing costs at their highest level since 2008.
Since the conflict in the Middle East began, the 10-year yield has risen by around 0.85 percentage points, putting gilts on track for their worst month since the “mini” Budget crisis in 2022.
The two-year yield, which is sensitive to changes in interest rate expectations, rose 0.13 percentage points in Monday morning trading to 4.7 per cent.
Traders in the swaps market are now fully pricing in three quarter-point interest rate rises by the BoE this year and more than a 75 per cent chance of a fourth increase. Before the conflict began, investors were expecting two cuts from the central bank this year.
Surging energy prices have fuelled fears that the UK could be facing a period of stagflation, where high inflation prevents the BoE from cutting interest rates to support a stagnant economy.
The UK’s blue-chip FTSE 100 stock index entered so-called correction territory on Monday, with a 2 per cent drop in morning trading taking its fall since the start of the conflict to 11 per cent.
The gilt moves were “starting to look very excessive”, said Derek Halpenny, head of research in global markets for Europe, the Middle East and Africa at MUFG, adding that the expectation of four rate rises was “way overdone”.
Investors are also worried that rising borrowing costs and measures to protect consumers from the energy shock will hurt the UK’s public finances.
Analysts at Société Générale said the combination of higher UK interest rates and the rise in gilt yields would wipe £9.5bn from the government’s £23.6bn headroom against its fiscal stability rule, highlighting the scale of the challenge facing chancellor Rachel Reeves as a result of energy-driven inflation.
They added that another £9.6bn could be wiped from the headroom by a “likely” 1 percentage point increase in inflation, which would raise the cost of paying back inflation-linked debt issued by the government.
Gilt yield moves have been further exacerbated by speculative investors being forced to exit positions because of the volatility, market participants said.
Gilts were suffering from a mixture of “stagflation, fiscal slippage and fraught positioning — an unholy trinity”, said Stephen Jones, chief investment officer at Aegon Asset Management.
Higher energy prices have prompted banks to rapidly adjust their expectations for growth and inflation in the UK. Morgan Stanley said on Friday that it has increased its forecast for the 10-year gilt yield at the end of 2026 to 4.6 per cent, compared with a forecast of 3.9 per cent going into this year.
“Investors may be starting to price in the risk of a ratcheting-up in fiscal support, as happened in 2022,” the Morgan Stanley analysts said.
