Gilt trip

• European equities added +1.2% in local terms
• Oil (Brent Crude) advanced +4.2% in dollar terms
• The dollar strengthened by +1.8% against the pound

• Major equity markets fell between -1.3% and -2.5% in local currency terms

The UK’s borrowing costs rose last week, with the yield on the benchmark 10-year gilt climbing to 4.9%, its highest since 2008, and the yield on the 30-year gilt to ~5.5%, its highest since 1998. Yields have risen in the US and eurozone too as persistent concerns around inflation and economic and geopolitical uncertainty pressure global sovereign borrowing costs, with forecasters now expecting fewer interest rate cuts in 2025. Sterling, which typically strengthens if borrowing costs increase, fell to its lowest level against the US dollar in over a year (~1.22) on concerns about the health of the UK economy.

Economists warned that rising borrowing costs could necessitate further tax rises or spending cuts if the UK government is to keep to its fiscal rule of not borrowing to fund day-to-day spending. Whilst the government will await the official borrowing forecast from the Office for Budget Responsibility (OBR) in March before commenting further, the situation represents a notable test for the UK’s new Chancellor, Rachel Reeves. As it stands, she has little headroom for costs to increase on a total Budget worth in excess of £1trn. However, comparisons with the Truss-Kwarteng “mini-budget” in Autumn 2022 appear overblown as thus far there have been no signs of the instability which then forced the Bank of England to intervene in bond markets. Despite the potential impact on fiscal stability, the market movements have not yet translated into higher mortgage rates.

Separately, December retail sales in the UK failed to inspire too much optimism on growth or inflation. Figures suggested consumers spent more, than over the same period last year, but 2024 overall was subdued. The British Retail Consortium (BRC) warned that 2025 would also be challenging, not least due to the increases in employers’ National Insurance (NI) contributions announced in the October budget. High street retailer Next commented that it would be raising clothing prices to help offset an expected £73m increase in wage costs. Food sales fared better over the festive period, but supermarket, Tesco, also noted that larger NI contributions will add c.£250m per year to its costs. The BRC suggested that these additional costs mean there is "little hope of food prices going anywhere but up" in 2025.

Equity markets sold off and expectations of interest rate cuts in 2025 were pared back to just one after two sets of strong US labour market data last week. The US economy added 256,000 jobs in December with the Non-Farm Payroll data beating expectations by 103,000, with the growth broad-based except in manufacturing. The Job Openings and Labour Turnover Survey (JOLTS) showed a further rise in vacancies to 8.1 million in November, the highest since May. Together with the unemployment rate being largely stable for months at around 4.2%, jobs data suggest the US employment market is relatively strong and comparable to pre-pandemic levels.

This strength and the Federal Reserve’s (Fed) recent minutes likely imply a pause in interest rate cuts until March or possibly even June. The minutes unsettled investors, revealing that most committee members judge the upside risks to inflation to have increased due to recent stronger readings on inflation and the effects of Trump’s potential changes to trade and immigration policies. Fed officials forecast that inflation will continue to move towards their 2% target, acknowledging that the process could take longer. Several officials expressed concern that disinflation had stalled, warning of the risks of further delays, noting that the Fed had reached or was approaching the point where it would be appropriate to slowdown the pace of monetary easing.

This week marks the start of the Q4 US corporate earnings season, which may shed light on inflation impacts and the hype surrounding artificial intelligence.

The 10-year government bond yield in China dropped to a new record low below 1.6% last week, with the entire yield curve for all maturities shifting downwards. Concerned about growth and inflation, investors have been buying government debt as a safe-haven asset; while the falling value of the yuan relative to the US dollar suggests that capital may also have been allocated to US treasuries as a higher-yielding alternative.

Falling yields (and therefore rising bond prices) on Chinese government debt also suggests investors are expecting inflation to remain persistently low. The annual average inflation rate rose to +0.2% in 2024 - in line with 2023 but well below the central bank’s target of 3% - while Producer Prices (the prices of goods bought and sold by manufacturers) fell by -2.3% year-on-year. The People’s Bank of China (PBOC) has expressed fears of a deflationary spiral crushing corporate confidence; they are expected to cut interest rates aggressively over the course of 2025 to stabilise growth (currently below the Chinese government’s state target of 5% at 4.6%) and revive consumption through monetary and fiscal policies.