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Dramatic shift in rates expectations: where do gilt yields go from here?
From cuts to hikes: a dramatic shift in expectations
The war in Iran has seen a dramatic repricing in global government bond yields and interest rate expectations due to its inflationary impact. Within this, UK gilts have underperformed – partly due to the UK economy’s greater sensitivity to global energy prices. However, with markets having executed a complete turnaround in expectations – from pricing in two cuts in 2026 to now pricing almost two hikes – we see good reason to be bullish on the outlook from here.
At a 10-year yield of over 4.8%, gilts are offering investors some of the highest yields in developed markets, with a reasonable amount of the negative impact from the Middle East conflict already priced in.
Inflation persistence key to gilt outlook
While the sharp rise in inflation has a significant impact on the short-term narrative for gilts, it is the persistence of inflation which drives the medium to longer-term outlook. Although the risks of a more prolonged conflict are elevated, high energy prices have likely not been sustained for long enough to present a more ingrained inflation problem. Additionally, squeezed UK household spending and soft corporate confidence is likely to reduce the extent to which inflation can become entrenched.
Bank of England Governor Andrew Bailey has said (on 1.1.26) that while the bank stands ready to act if inflation should become more persistent – "[The market is] still pricing us to raise rates. I would still say that is a judgment markets have to make but I think they're getting ahead of themselves." – we think the MPC is more likely to wait for further clarity before acting, and we will continue to monitor their messaging for any signal around their reaction function.
Positioning portfolios for gilts recovery
Although we recognise the economic risks of a prolonged conflict, we have positioned portfolios for a resolution which does not see a sustained elevation of energy prices. In this scenario, we expect yields to fall as the UK gilt market recouples with its trajectory of earlier this year.
Prior to the breakout of war in Iran, the outlook for gilts was constructive, with 10-year yields moving to their lowest levels in a year.
Growing confidence in UK government bonds had been underpinned by downward momentum to inflation, a labour market that was modestly loosening, and political efforts to reduce the credibility premium built into government borrowing costs.
Medium-term outlook supports long duration position
A resolution to the conflict should see the market return to focussing on the UK’s economic fundamentals. While the inflation outlook has risen, with the average analyst consensus for 2026 now around 3% versus 2% previously, the impacts of the war will also weigh further on an already tepid growth outlook and do little to halt the softening in the labour market which is helping to ease wage growth and domestic inflationary pressures. This is reflected in current economist expectations for inflation to fall back towards the 2% target in 2027 and 2028.
Given this medium-term outlook of easing inflation and tepid growth, we continue to hold our long duration position in the UK and have diversified by adding duration selectively elsewhere across our portfolios. So long as the situation in the Middle East remains highly uncertain, bond markets are likely to see ongoing volatility, so we will look to adapt and adjust positioning through that uncertainty.
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KEY RISKS
Past performance does not predict future returns. You may get back less than you originally invested.
We recommend this fund is held long term (minimum period of 5 years). We recommend that you hold this fund as part of a diversified portfolio of investments.
The Funds managed by the Fixed Income team:
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