UK 2-year gilt yields rise almost 6 bps on day to 3.880%

UK 2-year gilt yields rise almost 6 bps on day to 3.880%

UK 2-year gilt yields surged by almost 6 basis points (bps) on July 2, 2025, reaching 3.880%. This increase comes amidst the UK government's ongoing fiscal tightening measures, as outlined in the Spending Review 2025 (SR25) [1]. The rise in yields reflects market expectations of reduced government borrowing and potential shifts in monetary policy by the Bank of England (BoE).

The SR25 has introduced sweeping measures aimed at reducing the fiscal deficit by nearly £14 billion annually by 2028–29. Key initiatives include a 5% efficiency target for all departments, a 16% real-terms cut to administration budgets, and a £1.7 billion boost to HMRC's compliance teams to recover £7.5 billion annually by closing the tax gap [1]. These reforms are expected to stabilize debt-to-GDP ratios, which have been hovering around 90% since the pandemic.

The rise in 2-year gilt yields indicates that investors are anticipating a decrease in the supply of gilts due to reduced government borrowing. This, in turn, could lead to lower yields, benefiting bondholders. However, the economic impact of fiscal contraction is complex. While efficiency gains and digital transformation could support growth, austerity measures may also slow consumption and investment, potentially reducing inflationary pressures [1].

The BoE's stance on interest rates is closely tied to inflation dynamics. If fiscal tightening successfully reduces structural deficits but fails to revive productivity, the BoE might cut rates to stimulate demand, further depressing gilt yields. Conversely, if fiscal tightening fails to slow the economy, the BoE could remain cautious, maintaining higher rates to combat inflation [1].

Investors should monitor UK 10-year gilt yields and BoE policy expectations closely. A sustained drop in 10-year yields below 4% could signal a sustained rally in bond prices, particularly for long-duration securities. Instruments like the iShares GBP 15+ Year Gilt ETF (IGLT) offer leveraged exposure to rate cuts. Investors may also consider inflation-linked gilts, such as the iShares UK Inflation-Linked Government Bond ETF (ILGB), to hedge against residual inflation risks [1].

However, risks to this outlook include aggressive spending cuts triggering a sharper-than-expected slowdown and geopolitical tensions or Fed tightening counteracting UK-specific trends. Investors should prioritize flexibility, maintaining exposure to both government bonds and inflation-hedged instruments in an era of fiscal discipline.

References:
[1] https://www.ainvest.com/news/inevitable-fiscal-tightening-uk-tax-reforms-spending-cuts-reshape-interest-rates-bond-markets-2507/