Why sterling and gilts are sending different signals

September headlines have brought us crashing back to reality after the summer break. With UK long-term borrowing costs temporarily soaring to the highest levels since the 1990s, all this makes the economy sound almost uninvestable.

But at the same time, the pound is currently sitting at $1.36 against the dollar – up on a year ago, and far higher than the $1.03 it reached in the aftermath of the ‘mini-Budget’. Why are bond markets and sterling sending us such different signals?

Are gilt market signals flashing red?

First to gilts. The table below is, admittedly, not entirely reassuring. The last two columns show that long-dated bond yields remain higher than in peer economies and exceed the levels reached in the aftermath of the 2022 mini-Budget crisis.

But gilt market movements have many drivers. These include interest rates, inflation expectations, fiscal policy and risk appetite, which can all alter the appeal of holding long-term government debt. In the wake of the mini-Budget (the first two columns in the table), the UK stood out, proportionally speaking: yields rose, and the gap between 10- and 30-year yields widened in isolation. The movements were so ‘disorderly’ that the Bank of England (BoE) was forced to intervene in gilt markets on financial stability grounds. 

Today, higher interest rates have also dragged up yields in the US and Europe, while 30-year borrowing costs have risen across the board. Earlier this month, BoE governor Andrew Bailey played down these movements, warning people not to “exaggerate the 30-year bond rate”, which has a limited impact on funding costs. In the UK, 10-year yields are seen as more representative of government borrowing costs, and are used in the forecasts that accompany the Budget as a result.

What the value of the pound is telling us

Movements in the value of sterling also offer reassurance. Analysts at Dutch Bank ING note that the pound has been sitting in the top half of the table for G10 currency performance since the summer. This is partly a function of interest rates. In the UK, the base rate is still 4 per cent, and the path of easing looks uncertain for the rest of the year. 

Before the September rate-setting meeting, Bailey said that, given high inflation, there was “considerably more doubt” about when the BoE will be able to cut interest rates again. And high rates are a draw to investors. These inflows into sterling will bolster the value of the pound. 

But we can’t be too nonchalant. Interest rates are high because inflation is too – and this is contributing to nervousness in gilt markets. It is less attractive to lock your money away for decades if you fear that price increases will erode its value. The pace of quantitative tightening, changing patterns of demand and reliance on the ‘kindness of strangers’ are all feeding into the unhappy gilt market backdrop. 

Is there a chance that these fears will become so intense that they start to spill over into currency markets? Analysts at Capital Economics believe that, despite its difficult position, the government will be able to do enough to stave off a “bond market meltdown”. This should mean that we avoid seeing a persistent risk premium in sterling. 

But the atmosphere is still tense, and Capital forecasts “mini episodes of volatility in the weeks leading up to the Budget as speculation mounts”. UK markets are not in crisis, but they are not comfortable either. Matthew Ryan, head of market strategy at financial services firm Ebury, says investors will be “as calm as popcorn in a frying pan in the lead-up to the big day on 26 November”.