Equity Research; Gilts / Cash disconnect, why?

Gilts/ Cash disconnect, why?

Whilst normally a lower Bank Rate would boost gilt prices, the experience of 2024/25 has been sharp divergence, with cash rates lower, bond yields higher.

Since August 2024 the Bank of England has cut Bank Rate at regular intervals, with commentators describing its thinking as a ‘quarter [point] per quarter’.

But the 7th August 2025 meeting the Monetary Policy Committee (MPC) was split and the decision to cut a further 0.25% only just crossed the line by 5/4. The impression was given that the MPC’s mood was shifting to neutral and becoming vocal on risk factors.

Source; CSS Investments Ltd

The Bank of England decision to start an interest easing cycle (after a year at 5.25%) is 13 months old. Since the easing cycle started, UK CPI has moved up steadily, due in part to the October 24 inflationary budget which increased public sector payroll, business expenses and NHS funding.

Looking back on it, the UK’s high interest rate medicine only partially worked. The UK’s inflation problem has resurfaced in 2025 so the MPC’s reticence is due to the inflationary rebound and justified.

Source; Office of National Statistics

What are the pressures restraining inflation right now? Arguably these are ongoing cost of living pressures, weaker business and consumer confidence, and expectations of economic slowdown arising from geopolitical tensions.

The monetary brakes have been eased with the real rate almost negligible. Part of the problem is the lack of water depth under the monetary boat. Whilst the Bank Rate has been lowered to 4%, current CPI at 3.8% means cash investors are receiving just 0.2% in terms of a real interest rate, a poor return.

The new US administration in achieving significant tariffs on imports, alongside its insistence on increased NATO defence spending, and in other notable areas, has created a challenging unpredictable environment for NATO member governments with potentially significant new military expenditures.

Long gilt yields at 27 year highs

Significant movements in UK gilt yields along the yield curve has occurred since the BoE easing cycle began (the shift upwards from the purple dotted line to the blue line).

The sell-off is due to a combination of UK specific and international factors however some of the factors are more influential:-

a) Weak UK fiscal position; the UK budget deficit for FY25 (end March) at £151.9bn was the third highest on record. It is worth recalling the context for the two years that were worse: 2010 (post 2008/2009 financial crisis) and 2021(C-19). The UK deficit appears structural – with the new government missing an early opportunity to cut spending.

Some of the government’s spending cuts, i.e. the £1.5bn annual Winter Fuel Payment budget, have had to be reversed.

The November 2025 budget must strike a balance between revenue and austerity measures – though we suspect the main object will be non-voting targets – hence windfall taxes on large businesses.

Our view is the delay to the Budget to 26th November 2025 is to allow time to prepare for comprehensive measures. A deflationary Budget, if forthcoming, could be positively received.

b) Oversupply of gilts- gross capital issuance was £62.3bn in June, £67.5bn in May both higher than the six month average of £61.1bn. However, year to date net issuance was £32bn around £7.7bn lower than the same point last year.

Source; Bank of England

Whilst primary issuance (issuing new Treasury debt to pay for deficits) is high – bond auctions have been amply covered, even at the long end where prices have been weakest with bid coverage ratios typically above 3x. Whilst there is high gilt supply, as long as there is sufficient demand this appears to be sustainable, though not desirable, in the short term.

c) Rise in global yields and in particular US/ EU yields in 2025

Source; www.bloomberg.com

The rise in US T-bond yields despite US Federal Reserve cuts of 1% to Federal Funds rates is attributable to US debt concerns, the as yet uncertain impact of US tariffs on US inflation and concerns over the impact of geo-politics on T-bond demand.

The noticeable East/ West split that is more apparent since April US ‘Liberation Day’ and the loss of US support from key allies such as Canada, Mexico and India has led to questions about the willingness of overseas central banks, non US resident institutions to hold US Treasuries.

Furthermore the lack of support for the US Federal Reserve from the US administration and its public berating of its chairman and other board members is an unprecedented new departure that brings significant uncertainties with zero upside.

The possible loss of Federal Reserve independence is a major risk factor for US Treasuries and would undermine the central pillar of the US financial system, firstly the US central bank’s ability to address systemic and financial risk, and its ability to independently assess monetary and labour market conditions.

Moving to the EU bond market, substantial yield gains have also occurred.

Source; www.bloomberg.com

The rise in UK gilt yields at 26 basis points (1m) & 80 basis points (1YR) ‘tops the charts’ relative to EU sovereign debts. However this adverse movement of UK relative to EU is in our view due to the worse performance of UK inflation relative to EU inflation (the ECB has hit its 2% inflation goal).

The sharp increase in yield across the board represent debt concerns, breach of fiscal rules in France and other EU countries.

d) Changing Central bank preferences

There is mounting evidence of a decline in major central banks willingness to use US Treasury bonds and sovereign debt more broadly, as reserve assets. This is due to the belief that sovereign debt is growing at an unsustainable pace and in many instances there is limited political will to tackle debt challenges.

A major trend has been a willingness for central banks to replace sovereign debt with gold. Gold has significant qualities – a safe, liquid, asset agnostic to geopolitical risk. It seems also the safest bet for central bankers. ‘No-one ever got fired [for buying IBM] for buying gold’ (a well known 1960s/ 1970s idiom).

In a June 2025 report the ECB noted that gold assets now exceeded Euro denominated assets in its official reserves. This is also true for the USD – with recently data showing gold holdings surpassing US Treasury bond holdings in global central banks reserves though not in the US Fed.

Source: www.bloomberg.com

Changing preferences and a rising gold price, are likely to continue reducing overseas central banks’ gilt holdings.

Final point is there has been a sharp upwards yield movement in August 2025 – a very bad month certainly.

Source; www.bloomberg.com

Conclusion

The August 2025 gilt sell-off has taken UK government debt to their cheapest levels since the early days of the Blair government. The sell off lacked the drama of the Truss fiasco – with the notable difference being the latter took place in the context of a real catalyst, the unfunded ‘mini Budget’. But this time there has been no specific catalyst.

There were no failed Treasury auctions, or appeals to the IMF or sterling crisis, or any other major UK government drama to prompt the yield rise. The only major bond market event over August was the MPC meeting and the Bank of England cut to 4% (normally a bullish signal). In our view the understanding that the MPC was near to a neutral stance has led investors to conclude the BoE has likely reached the trough of the easing cycle.

The short end of the yield curve (under 5 years) is offering c. 4% is a steady, low risk return.

At the 12 year maturity gilt yields are at 5.04% and attractive in our view for those willing to lock in a decade of high returns.

PM Sir Kier Starmer’s 157 seat majority means the UK government can look through current struggles, and this is true for investors as well.

Markets are a continuum and assessments are a moving feast. In our view the BoE is close to the lowest rate of this cycle however uncertainty levels are high. A deflationary Budget next month and higher growth uncertainties could bring buyers back at these depressed levels soon. We would encourage investors to see this recent sell off as overdone, representing real value at current levels.

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