CONTRIBUTORS
Min Tian, CFA
Senior Global Macro Research Specialist
The UK economic picture has been clouded by persistent inflation and other challenges, which have kept the Bank of England less dovish and gilt yields higher than may be warranted. However, there are signs that the steepness in the gilt yield curve should normalize, creating opportunity.
Attractive valuation opportunity
Benchmark 10-year gilt yields are high on a standalone basis, trading well above levels that would be consistent with expected long-term growth rates and gross domestic product (GDP) growth forecasts. On a comparative basis, gilt yields versus GDP growth forecasts are elevated relative to peers (see Exhibit 1). This imbalance suggests gilts are cheaply valued relative to UK fundamentals.
Exhibit 1: 10-Year Bond Yields vs Nominal GDP Growth Forecasts
%, As of 31 May 2025
Source: Bloomberg (© 2025, Bloomberg Finance LP).
Perceived fiscal concerns spurred by government borrowing have impaired gilts’ safe-haven status, keeping risk premia and yields elevated. While UK debt metrics are not dramatically worse than peers, the combination of a large twin deficit and heavy reliance on foreign capital leaves gilts more exposed to changes in global risk sentiment. The government’s current fiscal strategy offers little room to maneuver, and fears of gilt oversupply, especially at the long end, have pushed up gilt yields. Spreads relative to German bunds and French OATs are high, underscoring the valuation opportunity (see Exhibit 2).
Exhibit 2: UK-Euro (Germany/France) 10-Year Spread
Basis points, as of 28 May 2025
Source: Bloomberg (© 2025, Bloomberg Finance LP).
A cross-market comparison also indicates that the gilt yield curve is steeper with the long end more sensitive to recent volatility (see Exhibit 3).
Exhibit 3: G3 30-year – 10-year Spreads
Basis points, as of 28 May 2025
Source: Bloomberg (© 2025, Bloomberg Finance LP).
Curve set to normalize
While gilt yields are high relative to developed market peers, several factors suggest the potential for the curve to normalize and yields to decline. Elevated gilt supply has remained a concern, but the government recently has shown greater inclination in managing long-end issuance, which should help to stabilize longer-dated bond yields. The latest Debt Management Office (DMO) update reflected a significant reduction in the share of long-dated gilts, dropping to 10% from 20% in FY2024/2025, suggesting a willingness to be flexible in responding to market demands and conditions.
Additionally, UK economic data may justify more Bank of England (BOE) rate cuts than currently priced into market expectations. Recent UK employment data was softer than expected and surveys indicate further labor market slack. Pay growth is also losing momentum as regular private sector earnings declined below BOE estimates. Virtually every pay settlement survey—from the BOE’s Agents’ network and monthly Decision Maker Panel (DMP) to Brightmine human resources data—shows pay deals this year are converging toward levels consistent with the central bank’s inflation target. As the labor market continues to cool, we expect services inflation to ultimately decline, prompting the BOE to abandon its cautious stance in favor of additional rate cuts. In our view, improved supply-demand dynamics and interest rate cuts should drive gilt yields lower over the remainder of the year.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.