Why are UK gilt yields rising in a slowing economy?

Traditionally, when economic growth slows, government bond yields fall and prices rise. Investors seek safety, central banks cut interest rates and bonds benefit. 

Today, that relationship has broken down. UK government bond (gilt) yields have risen even as the economic outlook has become more uncertain. 

Understanding why matters, not just for bond investors, but for anyone allocating capital across asset classes.

A different macro backdrop

At a high level, gilt yields reflect three core drivers:

In the current environment, all three have moved higher. 

The key catalyst has been a renewed rise in energy prices, which has pushed up inflation expectations. At the start of the year, markets expected UK inflation to fall back below the Bank of England’s 2% target - set by the government - paving the way for rate cuts. Instead, higher oil and gas prices have complicated that outlook.

This leaves policymakers in a difficult position. Inflation risks remain, yet growth is weakening. Markets have responded by pricing in a more cautious path for interest rates. That repricing has pushed gilt yields higher.

Why the UK stands out

While global bond markets have faced similar pressures, the UK has been particularly sensitive. 

There are two main reasons:

1. Inflation credibility. The inflation shock of 2022 remains fresh in investors’ minds. UK inflation rose more sharply and persisted for longer than in many other developed markets.

As a result, when inflation risks re-emerge - for example through higher energy prices - gilt markets tend to react more aggressively.

2. Fiscal and political sensitivity. The UK’s fiscal position remains a key consideration for investors. Periods of political uncertainty have heightened scrutiny of government borrowing plans and fiscal discipline. 

This sensitivity means that gilt yields can move more sharply than those in other markets when uncertainty rises. The experience of recent years has reinforced the importance of credibility and consistency in fiscal policy.

Rethinking the role of gilts

These dynamics have had a noticeable impact on gilt performance.

Over the past decade, returns have been weaker than many investors would expect from a core defensive asset. Volatility has also been elevated, at times exceeding that of other fixed income segments (see Chart 1). 

More recently, gilts have not always provided the diversification benefits typically associated with government bonds. During periods of market stress, they have sometimes moved more in line with risk assets than against them.

For portfolio construction, this raises an important question: should gilts still be treated as a reliable stabiliser?

The answer is not straightforward. While recent behaviour has been unusual, it is closely tied to the cycle of inflation, monetary policy and fiscal uncertainty. As those forces evolve, so too may gilt market dynamics.

What happens next?

Looking ahead, much depends on the path of inflation and energy prices.

We expect that inflation pressures will moderate over time. If energy prices stabilise or fall, this should ease upward pressure on inflation and allow the Bank of England to adopt a more neutral monetary-policy stance. In that scenario, gilt yields would likely drift lower.

However, the path is unlikely to be smooth. Political developments and fiscal announcements may continue to drive short-term volatility, even if the broader trend becomes more supportive.

Income, price and total returns

For investors, it is helpful to step back and consider how bonds generate returns.

At their simplest, bond returns come from two sources:

In a higher-yield environment, income becomes a more meaningful component of total return. At the same time, price sensitivity to changes in yields remains important - particularly for longer-dated bonds.

This distinction is particularly relevant in the gilt market. Securities with lower coupons tend to be more sensitive to changes in yields, while higher-coupon bonds offer more income but may be less tax-efficient for some UK investors. 

In practice, this means being more deliberate about duration, income profile and sensitivity to interest-rate moves.

Implications for asset allocation

The current environment presents both challenges and opportunities.

On the one hand, higher yields and elevated volatility require a more selective approach. Traditional assumptions about government bonds providing consistent stability cannot be taken for granted.

On the other hand, higher starting yields improve the long-term return potential of fixed income. They also offer greater income, which has often been limited in recent years.

In this context, areas such as shorter-dated bonds may offer a more balanced exposure, combining income with lower sensitivity to interest rate volatility.

A market in transition

The gilt market is in the process of recalibrating.

Recent volatility reflects a complex interaction between inflation dynamics, monetary policy and fiscal credibility. While these forces have disrupted traditional relationships, they are not permanent features.

As inflation stabilises and policy uncertainty diminishes, gilts may regain their more familiar role within portfolios. Until then, investors need to be more deliberate in how they access the asset class - focusing on income, duration and risk exposure.