Recent UK local election results have raised questions about political stability, fiscal discipline, and the outlook for government bonds. With Labour losing votes on both flanks and leadership uncertainty emerging, investors are reassessing the path of policy - and demanding higher yields to compensate. Yet while the bearish narrative for gilts is clear, it is equally important to consider what is already priced in, and where expectations could shift from here.
The recent local election outcomes have complicated the political backdrop. Labour shedding support to both the Greens on the left and Reform on the right suggests a fragmentation of the electorate that rarely leads to stable policy direction. The prospect of a leadership challenge - or at the very least, weakened authority for the Prime Minister - adds further uncertainty.
For markets, uncertainty is rarely welcome. The concern is not simply who leads, but what they are incentivised to do. If the political centre weakens, policy tends to drift outward. In this case, that likely implies a tilt toward more left‑leaning fiscal policy - potentially higher spending, more intervention, and less commitment to existing fiscal rules.
Bond investors are highly sensitive to such shifts. The UK has learned this lesson before. The “mini‑Budget” episode in 2022 showed how quickly gilt markets can react when fiscal credibility is called into question. While today’s situation is far less extreme, the mechanism is the same: if investors worry about rising borrowing, they demand a higher yield to compensate.
That process is already underway. The 30‑year gilt yield has risen back to levels last seen in the late 1990s, and 10‑year gilt yields have increased by around 0.6% so far this year - materially more than comparable moves in German Bunds or US Treasuries. This relative underperformance reflects a UK‑specific risk premium building into the market.
Complicating matters further is the inflation backdrop. The ongoing Iran conflict has begun to exert pressure on global supply chains - from fertiliser components to jet fuel - raising the risk of renewed price pressure.
As discussed in previous blogs, inflation expectations are central to bond pricing. Unlike growth shocks, which tend to support bond prices, inflation shocks push yields higher. This creates a difficult environment where bonds and equities can both struggle - particularly if inflation proves persistent.
For the UK, this risk is magnified. As a net importer of many goods, higher global prices are often transmitted quickly into domestic inflation. Even if the initial shock is external, the concern for policymakers - and markets - is whether it feeds into wages and longer term expectations.
The bearish argument for gilts is therefore straightforward:
In isolation, each of these factors would put upward pressure on gilt yields. Together, they form a coherent and widely discussed narrative - which raises an important question: how much of this is already priced in?
It is helpful to break gilt yields into three key components:
Gilts can rally (yields fall) if any of these components decline, provided the others remain stable.
Starting with inflation: while current risks are clearly skewed to the upside, there are plausible scenarios where expectations fall. A de‑escalation in the Iran conflict could quickly ease energy prices. Alternatively, even if inflation rises in the short term, subdued demand or weak labour markets could prevent second‑round effects such as sustained wage growth.
On growth: forecasts are already soft, with the IMF downgrading UK GDP expectations for 2026 and 2027. But growth can always disappoint further. A sharper slowdown - or recession - would typically pull yields lower, as markets price in weaker demand and a more accommodative monetary response.
Finally, the risk premium: this is arguably the most variable component. Political uncertainty has pushed it higher, but it could just as easily retrace if stability returns. Markets do not require perfection - only improvement relative to expectations. Even modest signs of fiscal discipline or political cohesion could prompt a reassessment.
We have seen similar dynamics before. In 2011–12, peripheral European bond yields surged as markets questioned fiscal sustainability. Yet once expectations stabilised - even without immediate improvement in fundamentals - yields began to fall.
Closer to home, the recovery in gilts following the 2022 crisis was not driven by rapid economic improvement, but by restored credibility and clearer policy direction. Again, it was the change in expectations that mattered most.
As I have noted in previous blogs, markets are forward‑looking mechanisms. The key is not simply what happens, but how it compares to what was already assumed.
The current environment makes it easy to be pessimistic on gilts. But as ever, investment outcomes are determined not by how compelling a story sounds, but by how reality evolves relative to expectations. In that respect, today’s elevated yields may reflect not just risk - but opportunity.
Ian is a portfolio manager of the Quilter Investors Cirilium and Creation Portfolios. Ian joined Quilter Investors in March 2020 from Seven Investment Management (7IM), where he was deputy chief investment officer. Ian also spent 15 years at Goldman Sachs in risk management and portfolio hedging strategies.
Ian is a CFA charterholder and has a degree in Physics from the University of Oxford.
