UK government bond storm is coming: stable buyers retreat, short-term capital dominates market volatility.

The landscape of the UK bond market is changing, making UK government bonds a weak link for the government to maintain stability in the current situation. Just this week, both the Bank of England and financial regulators have issued warnings that the changing demand structure poses potential risks, which could lead to greater fluctuations in bond prices, even triggering a sell-off. The message is clear: a market once dominated by prudent buyers such as pension funds and the Bank of England is now highly susceptible to the influence of unpredictable participants such as hedge funds and foreign investors, making it extremely fragile. For UK Prime Minister Keir Starmer and Chancellor Rishi Sunak, the problem lies in the fact that they have directly linked the government's economic policy to the movement of UK government bond yields, and they have pushed policies close to the limits of their own fiscal rules at a time when this shift is happening. This leaves their entire plan entirely dependent on the capricious market, and more sensitive to any changes in fiscal policy. The repeated unpredictable measures have not been effective, but the severity of the rapid changes in investor sentiment is due to a fundamental shift in the investor base. Liam O'Donnell, fund manager at Artemis Investment Management, said, "The UK is facing the biggest transformation in structural supply-demand relationships globally. If I look back at the biggest buyers of UK government bonds in the past 10 to 15 years, two of them are no longer participating in the market today." In the years following the significant decline in UK government bond prices that led to the downfall of the Liz Truss government in 2022, these securities are easily affected by any signs of fiscal overstretch. A recent example was last week when rumors about the new Chancellor of the Exchequer triggered a significant increase in yields. Even though the issue is not solely from within the UK, the UK market will still suffer heavy blows, indicating a deeper underlying problem. For decades, the UK has been able to rely on purchases by fixed income pension funds with almost infinite demand to meet its debt repayment needs, as these funds seek to match their debt obligations by investing in long-term government bonds. However, these purchases are gradually decreasing, while at the same time, the Bank of England (holding nearly 1 trillion of government bonds through its quantitative easing program) has been reducing its holdings of bonds, increasing the supply, as the government seeks more borrowing. The large supply combined with the departure of these two major buyers means others need to fill the gap. Global investment funds with investment strategies are intervening, but in recent years, due to the sharp declines in the UK market from Brexit to the Truss government bond crisis, these funds' buying willingness increasingly depends on prices. O'Donnell said, "The UK needs to attract foreign investment, but given the current political situation is so chaotic, I think this reliance is unreliable." While these circumstances are not unique to the UK, in many ways, the UK is at the forefront of the global bond market structural changes. Due to self-imposed fiscal rules, the UK is currently in a particularly difficult situation. In the March budget report, Sunak only left 100 billion in buffer funds to deal with these budget red lines. Subsequently, with policy reversals on spending cuts, slow economic growth, reduced tax revenues, and higher spending demands, the UK's finances are currently in deficit, with the deficit potentially reaching billions of pounds. This makes changes in UK government bond yields (an important consideration in fiscal rules as it reflects the government's cost of borrowing) crucial. Especially in longer-term bonds, their yields remain high, and this unstable fiscal calculation has led to embarrassing policy reversals by the government multiple times. Ven Ram, macro strategist at Bloomberg, said, "The UK is facing a dilemma of falling tax revenues without corresponding spending cuts, meanwhile, economic growth is also below pre-pandemic levels. This will lead to an increase in debt-to-GDP ratio. In addition, the cancellation of 50 billion in welfare spending cuts has added to fiscal pressures, and investors should demand higher real risk premiums and inflation risk premiums to hold longer-term government bonds." Policy makers are worried that government bond yields seem prone to sudden sharp increases. In the fall, a rapid and sharp increase in yields made Sunak's first budget plan lose public attention. Then in January, the cost of borrowing for 30-year bonds reached the highest level since 1998, bringing more unwelcome negative coverage to the government and laying the groundwork for austerity policies in March. The market turmoil caused by Donald Trump's tariff announcement in April also dealt a heavy blow to government bonds, further driving up yields. James Athey, fund manager at Marlborough Investment Management, said, "Lack of liquidity and imbalanced positioning means that price fluctuations are much greater than what the news warrants. The fundamental reason is the huge supply of UK government bonds and the government's 'poor fiscal calculations'." The UK's fiscal watchdog, the Office for Budget Responsibility, warned on Tuesday that the government is increasingly vulnerable to foreign investors as pension fund demand declines. One of the agency's models shows that this shift could lead to a 0.8 percentage point increase in government debt interest rates. Some investors also point out that the rise of hedge fund strategies has led to increased market volatility. In the first five months of 2025, hedge funds' activity in UK government bond trading on the Tradeweb platform accounted for 59% of total trading volume. This ratio is higher than levels in Europe and the US and has increased from 44% in 2020. The Bank of England also expressed similar concerns on Wednesday, warning that rapidly closing positions poses a threat to financial stability. Bank of England Governor Bailey noted that the actions of last week were the latest example of "greater market volatility at present."