Sterling sentiment cracks as bond pressure builds
Stress in global bond markets is once again weighing heavily on sterling, even without the disorderly moves seen in past episodes. Long-dated yields are climbing across the major economies, yield curves are steepening, and concern over sovereign debt sustainability and persistent inflation is intensifying. UK gilts have not escaped the trend. Thirty-year yields may not have surged yesterday, but they have quietly reached levels last seen in 1998, a milestone that is hard for investors to overlook.
Sterling has shown particular vulnerability. The pound is lagging its G10 peers, with GBP/USD suffering its sharpest single-day fall since April, when geopolitical headlines sparked a wider risk-off shift. The pair has slipped below 1.34 dollars, leaving little in the way of technical support until 1.32, while GBP/EUR has fallen under 1.15 euros, extending year-to-date losses to almost 5%.
Markets rarely move on new information alone. More often, they shift when lingering risks can no longer be ignored. The UK’s combination of stagnant growth, stubborn inflation, and a hawkish Bank of England has long left sterling exposed. Now, fiscal worries are coming to the fore.
The government faces a budget shortfall of an estimated £51 billion, adding to investor anxiety. Chancellor Rachel Reeves must juggle calls for spending restraint with party pressures and the likelihood of fresh tax rises in the autumn budget. These fiscal concerns are fuelling the rise in long-end yields and magnifying sterling’s fragility.
There could be some respite later this month. The Bank of England’s 18 September meeting is expected to review the pace of gilt sales. Governor Andrew Bailey has already expressed unease about market liquidity and curve steepening, hinting that quantitative tightening may be slowed, particularly at the long end.
For now, however, the UK remains at the centre of global bond market stress. In FX options, the volatility skew is flattening, showing that traders are braced for further downside in the pound. Elevated realised volatility is also keeping hedging costs high, underlining the caution surrounding GBP.
Volatility returns as summer ends
Market calm has faded, replaced by a repricing of risk that has been simmering for months. Long-term yields are grinding higher, curves are steepening, and investors are finally facing up to the structural challenges of fiscal fragility, sticky inflation, and uncertain policy.
Seasonal factors are also at play. With summer over and major trading desks back at full capacity, liquidity has returned and market reactions have become sharper. Moves that were tolerated in August are now provoking defensive repositioning across asset classes.
The dollar’s latest bounce reflects weakness elsewhere rather than an enthusiastic rush into safe assets. The yen remains under pressure from domestic political noise, while gold has lost momentum despite its record levels. Options markets continue to flag caution, with demand for downside protection staying high and hedging costs elevated.
Economic data added to the mixed picture. The latest ISM manufacturing survey showed new orders improving, but employment still soft. If this trend continues, the Federal Reserve may have scope to ease, though the effect could be diluted by global headwinds.
Attention now turns to Friday’s payrolls. A weak reading would reinforce expectations for rate cuts, while a firmer result could spark renewed political pressure on the Fed, adding yet more uncertainty to an already fragile backdrop.
Euro faces fiscal headwinds
The euro has been caught up in the same global bond turbulence, with rising long-term yields and fiscal concerns front and centre. France has emerged as a particular focus, with a confidence vote approaching and ten-year yields now around 80 basis points above Germany’s. The widening spread underscores how investors are starting to differentiate more sharply across the bloc.
While last week’s political headlines did little to rattle the euro, yesterday’s bond sell-off was a wake-up call, reminding markets that fiscal pressures are not limited to the UK. The reaction in FX was broad at first, but we expect longer-term impacts to be more country-specific, as yield risk premia reflect local conditions.
EUR/USD briefly approached the lower end of its recent 1.16 to 1.17 range before paring losses after the mixed ISM survey in the US. Our central case is that stronger American labour market data this week will push the pair below the 1.16 support level in the short term, with US fundamentals becoming the dominant driver of price action.
Negative sentiment towards the dollar has become increasingly hard to sustain, as fresh catalysts are needed to justify further weakness. The gap between spot EUR/USD and underlying rate differentials has narrowed compared with April and May, when the euro appeared comfortable above 1.17 even as fundamentals diverged. Going forward, relative rate spreads will need to bear more weight if the euro is to revisit the highs seen in July.
