A government takes office rather as Gulliver arrived in Lilliput: full of spirit and intent yet pegged to the ground by a great many small threads. In the UK, Westminster's new arrivals are very much in Gulliver's position when it comes to the bond market. Until they find a way to work themselves loose, they will struggle to do much else.
Britain may be the most striking example, but the question extends well beyond the UK. Sovereign yields have risen across developed markets this year, yet beneath those headline moves investors are pricing very different combinations of growth, inflation and policy risk. The UK shows why those differences matter.
Yields have risen everywhere this year. Ten-year gilts are up 69 basis points since the end of December, compared with 65 basis points in France, 59 in the US, 50 in Germany and 89 in Japan. The 10-year gilt touched 5.23% on 2 September, its highest since June 2008. Bond market moves are typically global as these broadly similar moves show. But there is an important difference in the UK. Since August 2024, Britain's 10 and 30 year bonds yields have moved from around the middle of the G7 pack to the top, where they have remained almost continuously. They are now some 30 to 50 basis points above their peers.
Sahil Mahtani, Director, Investment Institute: "The UK cannot simply blame the global bond selloff. Yields have risen everywhere, but in Britain they have been driven more by inflation expectations than elsewhere. Britain has moved from the middle of the G7 pack to the top and stayed there. The market is telling us that part of the problem is homegrown."
This has immediate consequences for the government. Higher yields mean higher government borrowing costs, eating directly into the Chancellor's room for manoeuvre.
Understanding why UK yields are rising is therefore not an academic exercise. It determines how much room the government has to spend, tax and ultimately deliver its agenda.
First, it is worth being clear about what is not driving the selloff. It is not simply the size of Britain's debt or deficits, which are not outliers. The UK has the second-lowest debt-to-GDP ratio in the G7 and the most aggressive deficit-reduction profile in the group, and yet still pays the highest nominal yield.
Mahtani: "Britain does not have the highest debt burden in the G7, but it does have the highest borrowing costs. That tells us debt levels alone cannot explain what the bond market is doing. The more important question is why investors are demanding a premium to hold UK debt."
Perhaps it is about political uncertainty?
The evidence this year suggests otherwise. For a start, the pound is up against both the euro and the dollar — an unusual response if investors were primarily worried about UK political risk.
The curve has also flattened by 12 basis points. Instead, UK two-year yields, which are particularly sensitive to expectations for inflation and Bank of England policy, have risen by 81 basis points this year. That points much more clearly to inflation and expectations for the Bank's response than to a fresh increase in political or fiscal risk. Ministers have seized on this argument: the rise in yields reflects an external shock from the Iran war, they argue, and Britain is hardly alone in feeling its effects.
Look a little closer, though, and the market is saying something less comfortable about the UK. The problem is not political uncertainty but certainty about an unfavourable direction of travel.
Mahtani: "The uncomfortable message from the gilt market is that this is being interpreted as a UK inflation story. Britain has been hit by the same global shocks as its peers, but the market is demanding substantially more compensation for inflation risk here. That is the part of the selloff the government cannot dismiss as imported."
The clearest evidence comes from breaking down the rise in 10-year yields into two parts: expectations for inflation and the return investors demand after accounting for inflation. Of the 69-basis-point rise in UK gilt yields this year, 57 basis points reflect higher inflation expectations and just 12 basis points from higher real yields. In the US, it is almost the reverse: only nine basis points come from inflation expectations and 50 from real yields, reflecting a stronger growth outlook.
Put simply, around 80% of the rise in UK 10-year yields this year has come from higher inflation expectations. In the US, it is just 15%. France is roughly evenly split. Germany has also seen around 80% of its move come from inflation expectations, but the increase in absolute terms is still smaller than Britain's.
The UK is an extreme example, but it points to a broader divergence across sovereign bond markets. The same global forces are producing very different outcomes: stronger growth is driving much of the rise in US real yields, inflation expectations are doing more of the work in the UK and Germany, while fiscal and political dynamics remain important elsewhere. For investors, that means the opportunity is increasingly in distinguishing between countries rather than making a single call on the direction of global rates.
Mahtani: "This is increasingly a market in which investors need to distinguish between countries, not simply make a call on global rates. A 5% yield driven by stronger growth is very different from a 5% yield driven more by persistent inflation. The UK is a particularly stark example of that distinction."
The distinction matters. Rising real yields can reflect expectations of stronger economic growth. Rising inflation expectations mean investors are becoming less confident that inflation will return to target as quickly as previously thought and are demanding more compensation for that risk.
Why is Britain so inflationary, and why is inflation proving more persistent than elsewhere? Poor government policy has constrained supply over long periods of time. Energy is among the most expensive and least secure in the OECD. Housing is difficult to build and infrastructure expensive to deliver. Meanwhile, population growth has substantially outpaced the expansion of the housing stock. The welfare transfer system is optimised for the spending needs of the bottom quartile of goods and labour. These constraints feed into rents and other domestic costs, creating inflationary pressures that cannot easily be solved by higher interest rates alone.
The way out is therefore clear, even if delivering it is not. Bringing inflation sustainably lower would allow yields to fall, ease pressure on the public finances and give the government more room to act. Without that, Westminster will remain hemmed in by the bond market.
Mahtani concludes: "Britain is a particularly clear example of a much broader shift. Global forces may move bond markets together, but they do not tell investors why yields are rising. For investors, understanding what is driving a yield matters as much as the yield itself."
In Swift's novel, Gulliver did get to his feet in the end, released after negotiations ended with him swearing conditions to the Lilliputians. Britain may be particularly tightly bound today, but the lesson for investors extends well beyond its shores.
