From safe harbor to the eye of the storm! UK government bonds fluctuate even more than stocks. Will the 2022 sell-off storm be repeated?

With volatility skyrocketing and the intense fluctuations surpassing those of the stock market, the attractiveness of the UK government bonds (also known as "Gilts") that have long been favored by global investors over the past century is facing a serious test. Some top asset management giants from Wall Street have even directly warned that one of the most popular bond assets of the century, the UK Gilts, now requires nerves of steel to hold. The once considered "cheap and safe" UK Gilts have now turned into high-volatility assets amidst the Middle East conflicts, fiscal concerns, and changes in market structure. During the recent round of Middle East conflict since the end of February, the UK government bond market has been more turbulent compared to similar markets in Europe and the United States. Even after reaching a preliminary ceasefire agreement earlier this week, the volatility remains high. Since the beginning of March, the two-year UK government bond yields, which are particularly sensitive to geopolitical news, have experienced fluctuations of at least 10 basis points in 12 trading days, marking the most unstable period for Gilts trading since the credibility crisis of the UK government in 2022. This intense volatility has led Vanguard International and Royal London Asset Management, among other Wall Street asset management giants, to adopt a more cautious approach towards UK government bonds. Other fund management institutions, including Insight Investment and M&G Investments, have also warned that the volatility may continue to remain high in the long term. UK Gilts face severe instability, "most crowded trade" undergoes reshuffling "The UK has recently been the most exposed market to such high-volatility and exceptionally intense market conditions driven by geopolitics," said Ales Koutny, head of global rates at Vanguard. He has closed his aggressive bets on UK bonds outperforming continental European bond assets. "We still believe UK assets look cheap, but now you need more resilience to face this volatility." As shown in the graph, the volatility of UK government bond yields far exceeds that of similar markets, and these intense fluctuations have made some investors cautious about exposure to UK government bonds. Before the outbreak of the Iran war, UK government bonds had become one of the most crowded trades in the fixed income space. Investors had expected the Bank of England to cut rates due to weakening labor market conditions, which would inevitably lead to a significant decline in UK yields. The new round of geopolitical conflict in the Middle East and the resulting surge in energy prices disrupted these optimistic expectations, forcing investors to consider the possibility of the Bank of England restarting rate hikes. "Over the past year, UK government bond assets have appeared particularly cheap," said April LaRusse, investment specialist at Insight Investment. "You are now facing a situation where suddenly everything we were looking at is seriously questioned." LaRusse pointed out that due to the open nature of the UK economy and significant fiscal and trade deficits, as well as dependence on imported energy, it is more susceptible to inflation and stagflation shocks compared to other developed countries. As shown in the graph, UK government bond yields are the highest among developed markets - the 30-year UK government bond yield has been above 5% for over a year. UK government bonds continued to decline on Friday, giving up some of the gains earlier in the week. Yields across the curve rose by about 4 basis points, with the 10-year yield slightly below 4.80%. At the peak of volatility in March, the yield had reached an astonishing 5.12%. "Over the past three to four months, this has been the most loved bond market," said Craig Inches, senior rates and cash manager at Royal London Asset Management. "We have maintained exposure to UK in our global bond fund, but due to volatility, we are now keeping the risk exposure at a relatively low level." Stalemate in the UK economy: fiscal shadows, changes in market structure, and political risks Inches warned that although war has changed the fundamental pricing prospects of the bond market, the concerns surrounding the UK fiscal outlook have made the UK government bond market itself more prone to intense fluctuations. The deficit concerns were one of the main driving factors in the collapse of UK government bonds led by the Truss government in 2022, which included tax cuts and spending plans. A bond fund that has still achieved strong positive returns amidst the record selloff in global government bond markets catalyzed by the Iran war last month is betting on the "stagflation" expectations. As governments around the world implement expansionary fiscal policies tinged with "populism" to cushion the blow from the energy shock, global bond yield curves will tend to steepen. In other words, as "developed countries spend money to please the people," the bond market may soon start to demand a price - especially as the "term premium" indicator may drive global long-term bond yields higher, triggering a sustained rise in long-term bond yields of 10 years and above. During a recent interview with the media, Guillaume Rigeade, co-head of fixed income at Carmignac, a French asset management company managing the fund, stated that as economies digest the shock to growth, governments are likely to respond with more aggressive fiscal stimuli - which will significantly raise the term premium, and consequently push up long-term bond yields of 10 years and above. The 10-year US Treasury yield is known as the "anchor of global asset pricing." If this yield indicator continues to rise under the term premium driven by fiscal stimulus, it will undoubtedly lead to a new round of valuation collapses in global hot assets such as high-yield corporate bonds, tech stocks, and cryptocurrencies. According to a performance comparison data compiled by institutions, the above-mentioned bond fund issued by Carmignac achieved an investment return rate of 0.5% in March, while the global government bond index plunged by 3.4%. This performance ranks it second among the 282 bond type investment strategy funds in the Morningstar Direct Euro Flexible Bond category. The recent trading performance of UK government bonds resembles that of Italian government bonds during the European debt crisis years ago, and investors tend to view the latter as a riskier bet compared to ultra-safe bond assets like German bonds. According to data compiled by institutions, over the past month, UK and Italian government bonds have performed similarly, with a decline of 0.2% in returns for both, with UK government bonds showing slightly weaker performance. In addition to making investors increasingly uneasy, the persistently high volatility is also having an impact on the broader UK economy. Due to the severe fluctuations in the interest rate swap market, mortgage lenders have withdrawn mortgage products, leading to a significant decline in housing purchase demand in the UK in March. This volatility also makes fiscal planning for the UK government more challenging and complicates the financing prospects for businesses, as companies may be reluctant to issue bonds in such an environment. However, there are other factors at play behind these fluctuations. As a relatively small sovereign-level bond market compared to larger and more liquid bond markets, the volatility in the UK market may be overly amplified. At the same time, changes in demand structure make UK government bonds more susceptible to the sentiments of volatile investors such as hedge funds, who often seek to increase returns through leverage. Meanwhile, the demand from more stable buyers such as pension funds, known for their long-term and cautious approach, is on the decline. "Over the past five years, the structure of our core government bond markets has changed dramatically," said Andrew Bailey, Governor of the Bank of England and Chairman of the Financial Stability Committee, on Thursday. "Leveraging forces are indeed more present, and pricing in the market often fluctuates more sharply." The next major test will come in the May local elections, which are gradually evolving into a severe test for Prime Minister Keir Starmer's ruling party. Starmer faced calls to resign from within the Labour Party last year, and the prospect of a potential leadership struggle looms large in the minds of global Gilts investors - they still vividly remember the crisis in 2022 that led to the downfall of former Prime Minister Liz Truss. Overall, these risks imply that global "fast money" traders from leveraged hedge funds and other institutions may adopt a more cautious stance towards the UK bond market. "There is indeed some kind of semi-permanent risk premium here," said Andrew Chorlton, Chief Investment Officer for fixed income at M&G. "It is still paying the price for things that are happening under completely different governments and policy agendas."