We love bonds, but we hate it when they make the front page. Let’s face it, while they are intellectually fascinating, there are no good news stories about bond markets. It’s always “someone’s defaulted”, “someone’s crashing the economy”, or some other such awfulness.

Readers would have found it hard to miss the excellent coverage that rising bond yields have generated over the past few months. Or indeed the front-page news that gilts have generated over the past 24 hours.

There is an excellent explainer of what the current malaise means for the government — and for UK citizens more generally — on MainFT.

But we think it is worth unpicking a simpler nerdier question: what has happened to bonds over the past few months?

Stepping back, most of the time the best answer to the question ‘why have gilts yields gone up/down?’ is ‘the Treasury market’.

While gilts don’t move basis-point-for-basis-point with Treasuries — and the possibility of divergence is ever-present — the 10yr gilt and 10yr Treasury have tended to drift together over the medium-term. Bunds too tended to move in lock-step with US government debt until the Eurozone crisis put a spanner in the works for European growth.

Post-EU referendum, gilts traded in limbo for a few years, undecided as to whether to join Bunds in discounting economic stagnation, or Treasuries in discounting reflation. Following the Liz Truss mini-Budget shock of autumn 2022, they’ve moved back to trading pretty much in line with Treasuries.

The global rise in yields since mid-September may look unremarkable on such a long-term chart. But the sell-off is nevertheless both interesting and important. Firstly, because of the nature of the sell-off. Secondly, because of the implications it has for other markets, as well as government finance.

‘Nature of the sell-off’? Is FTAV getting ‘notions’? Is there really any more to say than “Line go up, monkey sad”?

Yes, actually.

The recent low point in gilt and US Treasury yields was 16th September 2024 — two days before the Federal Reserve cut rates by 0.5 percentage points to 4.75–5.0 per cent, and three days before the Bank of England held rates steady at 5 per cent. Both the Fed and the BoE have since cut rates by 0.25 percentage points (on 7th November).

Since that proximate yield low, ten-year Treasury yields have increased by 1.08 percentage points and ten-year gilt yields have increased by 1.02 percentage points — to 4.7 per cent and 4.8 per cent respectively, increasing the annual cost of any new debt being issued, and pushing down the value of existing bond holdings.

We know that nominal bond yields, and changes to them, can be sliced and diced into long-term inflation expectations (so-called breakeven inflation rates) and real yields (aka the amount you are promised after accounting for inflation). How much of the yield increase has been due to a bump up inflation expectations? Some. But mostly the rise in bond yields is due to an increase in real yields.

There is no shortage of theories as to why inflation-linked bond yields should trade where they trade, although no falsifiable ones that we have yet come across. They can almost be thought of as the tradable r-star of financial markets — the market’s best guess as to the medium-term equilibrium real rate for the economy as a whole. Though some people think r-star is a load of baloney.

Real yields for gilts have tended to be lower than they are for US Treasuries over the past decade. Going by the whole tradable r-star theory, you could be forgiven for thinking that this gap reflected market expectations for lower trend economic growth. And, frankly, who knows? But a common belief among UK investors is that inflation-linked gilt yields are lower than you might otherwise expect because UK private sector defined benefit pension schemes tend to have inflation-linked liabilities  — and the sheer size of these buyers looking to hedge their risk depresses linker yields to lower levels. 

Here’s how real yields have evolved over the last few years:

With nominal bond yields roughly translating into expectations for average central bank policy rates over a given time horizon, real yields squeezed lower by structural pension demand will have a counterpart in higher breakeven inflation rates. And this is one explanation for the mandate-busting level of breakeven inflation rates that have been common to the UK market for most of the past fifteen years.

Today the level of inflation that would make equivalent the total return of ten-year UK inflation-linked gilt to a ten-year conventional (non-inflation-linked) gilt is around 3.6 per cent per annum. This is a lot of inflation. But it’s not drastically different from the 3.3 per cent per annum breakeven inflation rate that has been priced into the market on average for the last decade.

Breakeven rates and real yields are not the only way we can slice and dice bond yield changes. As we learned in bond boot camp, yields also slice into market expectations of overnight interest rate swaps (the average policy rate expected by the market) and asset swaps (the amount that governments have to pay to rent private sector balance sheets, aka term premia).

Most of the increase in 10-year bond yields over recent months is accounted for by the market repricing the course of respective central bank policy rates over the next decade. And this cool chart made with data supplied by Christian Mueller-Glissmann from Goldman Sachs shows the degree to which longer-dated bond yields have moved around with expectations for very short term Fed rate action. In September the option markets priced a sixty per cent chance of eight or more cuts over the next twelve months. It now prices a 30 per cent chance of one or more hikes for the year.

But on this side of the pond, gilt yields have increased a little more than might be accounted for by expected Bank of England moves alone. Lawrence Mutkin, head of EMEA rates strategy at BMO, points to this term premium as something that is increasingly becoming a big deal for bond markets across the globe. As he puts it:

when Term Premia increase for the government, so do Term Premia for everyone else. This is what “crowding out” looks like.

How might central banks respond to rising term premia? Maybe by cutting rates? If so, this — argues Mutkin — is fiscal dominance in action. 😬

How has this term premia been developing? Not well. While gilts have cheapened against swaps quite a lot over recent months, this merely takes them to levels already achieved by US Treasuries against their swap curve. Is this the result of QT / over-abundant government issuance? Answers in the comments please. 

Now we realise we’ve flung a large number of charts at you. And while it isn’t typically the done thing, we don’t really see why we shouldn’t chuck these different slicings and dicings into a single holistic graphic overview to show not only what has happened to ten-year bond yields, but other tenors too.

So while the answer to the question “how much have bond yields risen since mid-September?” is “close to one percentage point for bonds with anything from five years to thirty years left before maturity in the Treasury and gilt market alike”, the reason for these moves vary:

In both markets, the simple reason why bond yields are higher is that markets expect the Federal Reserve and the Bank of England to have higher interest rates over not only the next year, but over the next five, ten, even thirty years than they did in mid-September.

At the same time, bond market measures of inflation expectations haven’t leapt, but this could also be because markets expect the Federal Reserve and the Bank of England to have higher interest rates than they did in mid-September.

In the UK there’s been some cheapening of gilts against swaps, with ten-year gilts term premia rising rapidly towards the levels seen in the US Treasury market.

None of this really helps you understand the intraday moves in bond markets that occurred yesterday — variously interpreted as some sloppiness from investment banks in managing rate locks, to the results of a meh five-year gilt auction, to bond vigilantes testing the Chancellor’s mettle. But we hope it provides some useful context.

Further reading:
— The sterling sell-off will continue until morale improves
— Everything you always wanted to know about bonds (but were afraid to ask)