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Credit FAQ: G7 Bond Market Developments With A Spotlight On Gilts

This report does not constitute a rating action.

Since the beginning of 2025, there has been a notable rise in yields for government debt across the U.S. and European bond markets, as well as for U.K. gilts, alongside a considerable steepening of the yield curve. In this report, S&P Global Ratings examines the background behind recent market moves; the relationship between monetary policy and fiscal outcomes in the U.K. and the effect of higher cost of financing on the U.K. sovereign rating; and implications higher funding costs could have for other G7 governments' fiscal policy this year.

Why Is The U.S. Treasury Selloff Spilling Over To Europe, Despite Diverging Macro-Inflation Stories?

Uncertainties about U.S. trade tariffs and immigration policies--amid persistently high budget deficits in advanced sovereigns--seem to be the principal source of contagion between U.S. and European bond markets.  This is despite plenty of evidence of macroeconomic divergence between the U.S. and Europe. In Europe, household saving rates remain high and consumption is soft, whereas inflation, excluding services, is declining. Moreover, rapidly narrowing corporate profit margins in Germany and France also suggest lower pricing power in the corporate sector (though at the same time mortgage demand in Europe is on the rise) and hence downward pressure on inflation.

Did The Recent Bond Market Selloff Only Result From Loose Fiscal Policy And Inflationary Risks?

The selloff, which started at the end of 2024, has been fairly broad-based across the safe asset space, also affecting sovereigns with comparatively stronger fiscal positions, such as Germany.  Amid persisting uncertainties about future U.S. trade policy and lingering inflationary pressures, one of our key convictions is that central banks will not go back to the historically low interest rate levels seen before the COVID-19 pandemic. We think that would, in turn, underpin a higher for longer cost of financing for developed market sovereigns.

We also believe that the market is becoming more price-sensitive amid quantitative tightening.  The volatility of borrowing costs for large G7 governments is, of course, no accident. Rather, it is one of the expected consequences of the G7 central banks' decision to shrink their balance sheets since 2022 to help contain inflationary pressures. As central banks have replaced government bond purchases (quantitative easing [QE]) with government bond sales (quantitative tightening), the supply of government debt has increased in the financial markets. This--alongside fears of more persistent inflationary pressures in the U.S., potential deflation in China, outright stagflation in the U.K., a more volatile economic outlook, and increasing fragmentation globally--has led to steeper yields and renewed concerns about weak fiscal positions in many advanced economies (see chart 1).

Chart 1

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What Is The Peculiarity Of The Relationship Between Monetary And Fiscal Outcomes Specifically In The U.K.?

For any sovereign, monetary and fiscal policies are ultimately always related, but in the case of the U.K., the short-term link is even more direct, given the quarterly compensation to the Bank of England (BoE) from the U.K. Treasury for losses from QE operations.  This reflects the agreement between the BoE and HM Treasury (HMT) in 2009 that HMT shielded BOE from any losses materializing from administering the quantitative easing program via the newly established Asset Purchase Facility (APF). From the outset, the APF was set up in a way that any of its aggregate profits or losses would ultimately be passed on to HMT. In 2012, the BoE and HMT also established that profits or losses generated by the QE facility will be reflected in the public finances on an ongoing, quarterly basis rather than accumulate at the APF until some indeterminate future date. Although the APF facility has initially resulted in profits transferred to the HMT, since 2022, HMT had to make payments in the other direction to cover for losses from APF's operations. The losses reflect both what can be called the net flow component (difference between the coupon payments on gilts held by the APF and the base rate BOE has to pay on commercial bank reserves used to ultimately fund the APF) and the valuation component (loss made for gilts originally bought at a higher price that are subsequently sold for a lower value in the market). The former effectively implies that the interest rates HMT pays on just under 26% of the central government's outstanding debt are essentially floating--that is, they are priced at the BOE's base short-term rate, which currently stands at 4.75%.

How Large Have The Fiscal Transfers Between the BoE's QE Facility and U.K. Treasury Been To Date?

For over a decade, APF turned an annual profit which was regularly transferred to HMT, but this has turned into an annual loss from 2023 requiring growing transfers in the other direction to indemnify the BoE.  For the accounting period ending Feb. 29, 2024, for example, the cash transfer from HMT to APF totaled £44.5 billion or 1.6% of GDP (see chart 2). As gilt yields increase (and hence their prices decline), the fiscal cost of quantitative tightening also increases, making fiscal planning more challenging.

Beyond that, a contingent future fiscal risk to HMT is the possible crystallization of so far unrealized mark-to-market losses on gilts that APF still holds.  Over 2023-2024, these were equivalent to between 5% and 6% of U.K. GDP. These unrealized losses do not require an upfront cash transfer and could eventually be reversed, depending on how rapidly the BoE sells down its gilts portfolio and on gilts valuations over the next few years. This, in turn, depends on inflation outcomes and base rate decisions by the BoE. Under a more pessimistic scenario, there is a risk that so far unrealized losses could crystallize or even grow further.

What Is The Direct Exposure Of U.K.'s Government Debt Profile To Changes In Inflation Compared To Other G7 Sovereigns?

The U.K. also has the highest proportion of inflation-indexed debt (23% of government debt) of any G7 borrower.  For example, amid elevated inflation in 2022, HMT paid 4.3% of GDP on interest payments alone versus 2.5% in the U.S., 1.9% in France, and 4.1% in Italy. As inflation eased in 2023 and 2024, the U.K.'s interest expenditure quickly declined to 3.2% of GDP in 2023 and an estimated 3.0% of GDP in 2024. Such large movements in interest expenditure create an unusual degree of upfront fiscal uncertainty for HMT during periods of inflation uncertainty, such as today.

Chart 2

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The U.K. Is Currently Suffering From Direct Fiscal Losses Stemming From Its Monetary Policy Arrangements. Is There A Precedent For This?

There is a long history of efforts by central governments to minimize the fiscal costs of monetary operations.  One example of this was the European Central Bank's approval of the Irish government's 2012 exchange of a $4.1 billion promissory note into longer-maturity, low-interest-rate obligation, held by the Irish Central Bank due to its provision of emergency loans to a state-owned bank. The transaction enabled the Irish exchequer to avoid the need to make heavy cash interest payments to the Irish Central Bank. This provided considerable fiscal relief to the Irish state and helped stabilize Ireland's fiscal position in 2012.

Could The BoE Relax The Pace At Which It Is Unwinding Its QE Gilt Holdings?

The bank adopted QT in pursuit of its price stability mandate--that is to fight off current inflationary pressures.  While it is also committed to avoid any disruption to the financial markets and to conduct gilt sales gradually and predictably to smooth the impact on interest rates, we do not think there are enough reasons for the BoE to change course now for several reasons.

First, the recent increase in gilt yields largely reflects broader market dynamics and closely follows the move in U.S. treasury yields, for example. The BoE cannot control those external factors.  According to our estimates, on average, 80% of changes in U.S. 10-year yields are reflected in the U.K. gilt market. The very close trajectory of gilts and treasuries illustrates the point that the repricing is not U.K.-specific (see chart 3).

Chart 3

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Second, the Monetary Policy Committee at the BoE currently focuses on how to reduce inflationary pressures.  This means its current monetary policy stance is restrictive. As a result, higher financing costs are not necessarily at odds with its objectives.

Third, the interest rate is a more powerful tool than QE to control the price of money in the economy if the BoE starts to worry about negative effects on growth.  The BoE has plenty of room for adjustments, with interest rates at 4.75%. If the BoE considers that the cost of financing is too restrictive, it is more likely to reduce its main interest rate than use QE, in our view. As such, with the latest inflation print continuing to show an easing of price pressures and growth remaining weak at the turn of the year, we continue to expect the next rate cut in February this year and another three until the end of 2025.

Finally, previous actions by the BoE suggest that it currently prefers to gradually downsize its significantly expanded balance sheet with a long-term view of avoiding its persistent growth to retain the ability to credibly conduct QE policy once again in the future if necessary.  Additionally, the renewed focus on fiscal discipline may not be something the BoE would want to disturb, unless unwarranted liquidity risks appear in the market.

What Are The Implications Of These Market Moves On U.K. Growth And Housing Markets?

For the U.K. economy, the more immediate effect of higher market financing costs is an increase in investment costs and therefore a likely reduction in capital spending.  In the U.K., mortgage rates are quite sensitive to changes in the gilt market and the housing market is usually one of the first to feel slowing demand from the effects of higher borrowing costs. However, the recent increase in yields might not be entirely permanent for the U.K., limiting the economic impact. Higher bond yields have been largely driven by global factors and are at odds with our expectations of further BoE rate cuts.

In our view, the rise in financing costs is also putting more pressure on the government to spend efficiently.  So far, the new Labour government policy outlined in the October budget has yet to deliver. While higher spending on public services might be good for long-term growth, over the short term, higher taxes and cost of financing could hinder investments and employment plans while also contributing to higher output prices. A key consideration for us remains whether higher public investments and extra spending on public services will be effectively delivered, thus successfully addressing existing problems. A hypothetical scenario in which public spending is permanently higher but the quality and accessibility of public services still does not improve enough, could further complicate policy trade-offs in the future.

What Are The Implications Of The Recent Government Bond Market Moves For The U.K. Sovereign Rating?

In our view, albeit U.K.'s fiscal position is constrained, it remains manageable and the recent rise in cost of financing does not have immediate implications on our sovereign ratings on the U.K.  We project that the U.K.'s primary budgetary deficit will improve by close to 0.9% of GDP to a primary deficit of 1.3% of GDP during 2025, or over 2x the underlying fiscal consolidation projected in either France or the U.S. That said, the degree of volatility in interest expenditure for the U.K. is a concern. The U.K.'s Office of Budget Responsibility estimates that a rise in the cost of new financing by 100 basis points (bps) increases the fiscal cost of interest payments for the central government by 0.4-0.5 percentage points (ppts) of GDP over a 12-month period. This is a considerably faster pass-through than in eurozone sovereigns, such as France with 0.1-0.2 ppts.

What Implications Do Higher Rates Have For Other G7 Governments' Fiscal Plans?

In our view, developed market sovereigns, many of which have vulnerable fiscal positions, could face renewed pressure to contain their elevated post-pandemic levels of government debt in relation to GDP.  G7 governments have some of the longest-dated debt profiles (including bills) globally. With the exception of the U.K., most G7 sovereigns have limited indexed obligations. That means the higher cost of raising new debt generally affects the overall debt servicing costs for the whole debt stock only gradually , compared with most emerging markets, where domestic savings are typically more limited, and where debt profiles are less resilient. Nevertheless, in our view, historically, market pressure has been far more effective than the national fiscal watchdogs, legislatures or the European Commission in checking governments' fiscal profligacy. We expect the cost of financing pressures to remain a theme throughout 2025. We also forecast that it will lead to policy responses in advanced and emerging economies, and that there could be efforts to neutralize the fiscal effect of monetary policy.

Related Research

Primary Credit Analysts:Frank Gill, Madrid + 34 91 788 7213;
frank.gill@spglobal.com
Maxim Rybnikov, London + 44 7824 478 225;
maxim.rybnikov@spglobal.com
Senior Economist:Marion Amiot, London + 44(0)2071760128;
marion.amiot@spglobal.com

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