Balancing gilt market risks

The UK gilt market is showing signs of strain, as economic and political pressures deepen. While short-term (two-year) yields are falling in response to Bank of England easing, the 10-year rate remains stubbornly high at around 4.6%.¹ The UK now has the dubious record of having the highest borrowing costs at 10-year bond maturities out of all developed economies. 

An indicator of short-term investor anxiety came during Prime Minister's Questions in the Commons on 2 July where we saw a visibly upset Chancellor Rachel Reeves. Gilts sold-off briefly, possibly on the back of speculation that the chancellor could lose her job, underscoring the idiosyncratic risks that are present in the UK bond market. 

Over the long-term, the fiscal watchdog, the Office of Budget Responsibility (OBR), released some sombre thoughts on the outlook for government borrowing in its ‘Fiscal risks and sustainability’ report in early July. The OBR warned that efforts to stabilise UK public finances have seen only limited progress. Major economic shocks like the pandemic and energy crisis, coupled with generous government support, have contributed heavily to drive up the debt to GDP ratio.

Borrowing continues to remain high post-crisis, largely because the government has abandoned fiscal consolidation plans, since proposed tax increases have been rolled back and, more notably, intended spending cuts were scrapped.

We look at three areas of concerns in the gilt market:

1. Growth optimism 
Official projections for UK gross domestic product (GDP) growth from the OBR hover near 1.9% for 2026, higher than market consensus of roughly 1.2% from economists.² For 2027, the OBR forecasts 1.8%, against 1.5% for economists.³ These OBR forecasts rely heavily on productivity surges and widespread adoption of technologies, like artificial intelligence. Nevertheless, productivity in both the private sector and public services remains depressed. If growth estimates are scaled back during the autumn budget, this would reduce expected tax revenues and make it more difficult for the Chancellor to meet her self-imposed fiscal targets.

2. Shrinking fiscal headroom
The combined cost of Labour’s U-turns on welfare reforms and winter fuel payments is estimated at £3.75 billion.⁴ If real GDP growth is downgraded by just 0.1–0.2%, JPMorgan estimates a budget shortfall between £9–18 billion could emerge.⁵ The Chancellor could face a new black hole that must be closed if she is to meet her self-imposed fiscal rules by the time of the autumn budget. Currently, there is only £10 billion fiscal headroom. This could pressure the government to raise taxes—potentially clashing with key Labour party manifesto pledges. 

3. UK Politics
Public support for Reform UK, led by Nigel Farage, has surged while support for Labour and the Conservatives continues to slide. According to Electoral Calculus, current polling suggests Reform UK could win 325 seats, up from just five today, placing it on the brink of a parliamentary majority. In contrast, Labour would slump to 145 seats (from 472) and the Conservatives to 41 (from 121). This sharp shift in popularity is casting doubt on Prime Minister Keir Starmer’s leadership. Any reshuffling at the top could unnerve markets as potential successors may differ significantly in fiscal strategy, affecting everything from wage policy to deficit control. 

Moreover, the constant turnover of chancellors is unlikely to inspire investor confidence. There have been eight over the past decade - matching the uninterrupted tenure of Gordon Brown in the same role.

Gilts can play a role as a portfolio diversifier and potential hedge should equity markets fall. Yet in 2025, gold has outperformed gilts in both sterling and dollar terms, reaffirming the importance of flexible asset allocation. Hedge funds and shorter-dated bonds offer additional stability amid volatility.

Looking ahead, investors should be mindful of the risks explored above and balance these against the current high level of yields offered by UK gilts. A nimble approach will be essential for navigating the complex mix of macroeconomic headwinds and political uncertainty.

1. Evelyn Partners/LSEG
2,3. Bloomberg
4. The Standard, Labour's welfare U-turn will cost £2.5bn, MPs are told as government looks to appease rebels, June 2025
5. JPMorgan, Global Data Watch, July 2025