Bond markets have not reacted much to the UK general election result, which Labour won with a substantial parliamentary majority as expected. This contrasts with a notable market reaction following the recent parliamentary elections in France and for the European Parliament.
Analysis by the National Institute of Economic and Social Research (NIESR) suggests that the surprise election results in Europe may have caused financial market volatility due to increased perceptions of risk among investors. A lack of comparable volatility in markets following the UK election result indicates just how confident investors felt about a Labour win.
Bonds and the yield curve
A UK government bond, or gilt, is essentially a loan that investors can extend to the government in exchange for interest payments, on top of the full value of the loan repaid at the end of the asset’s lifetime.
A bond’s yield tells an investor how much money they can expect to receive in return for holding that bond. Conversely, gilt yields indicate how much it costs the UK government to borrow from investors.
To understand the dynamics of ten-year gilt yields, NIESR produces a quarterly term premium tracker that breaks down these yields into two components: expectations of the future path of gilt yields; and the term, or risk, premium.
The first component captures the average of current interest rates and investors’ expectations about the future path of interest rates. When an investor buys a bond, they will receive a fixed interest rate on that bond until it matures.
But interest rates can change – say, if the Bank of England’s Monetary Policy Committee (MPC) decides to raise interest rates in order to control inflation. So, bonds issued at different points in time may offer different interest rates (and thus, different yields).
For simplicity, we refer to this combination of current interest rates and future expectations of interest rates as ‘interest rate expectations’.
The second component – the term premium – represents the compensation that investors require for bearing the risk that bond yields will not evolve as expected. As noted in this NIESR article, the UK term premium has been negative since the start of the Covid-19 pandemic. This is likely to be because the large-scale asset purchase programmes that were conducted by central banks during this period (quantitative easing or QE) served to distort market pricing. Thus, in this article, we focus on shifts in the term premium rather than on its level.
Neither of the two yield curve components is directly observable, so NIESR employs a research-informed methodology to estimate them (Adrian et al, 2013). It should be noted that this methodology does not allow us to make any causal claims about what is driving movements in interest rate expectations or term premia.
That said, we can use economic theory alongside assessments of the direct impact of known events (such as an election), in combination with our estimates, to get a deeper understanding of movements in the yield curve.
Figure 1: UK ten-year government bond yield decomposition
Source: NIESR estimates up to 8 July 2024 based on Bank of England data
Figure 1 plots the evolution of the UK ten-year gilt yield since January 2021. This yield has been on a broadly upward trend since January 2021, in line with the rise in policy interest rates – those set by the MPC. In 2024, it has stabilised around 4%, on average.
We can see that the rise in the past three years has been driven by increasing interest rate expectations, which are most likely to be in response to the MPC’s aggressive monetary policy tightening cycle during this period.
That said, interest rate expectations have been on a decreasing trend since mid-2023. This is likely to reflect expectations that the MPC can begin to cut interest rates as consumer price index inflation has been falling.
On the other hand, the term premium on the ten-year UK gilt yield has been relatively stable throughout 2024, although it has risen noticeably since the elections for the European Parliament in early June and has yet to recover.
How have bond markets reacted to the UK’s general election?
In short, bond markets have not reacted much to the UK’s general election result. This is not particularly surprising given that the outcome was largely expected on the basis of repeated pre-election polling. What’s more, Labour’s current economic plans do not represent a significant deviation from the policy status quo.
Between 4 and 5 July, the term premium on the UK ten-year gilt yield fell by less than one basis point (one-hundredth of 1%) and corresponding interest rate expectations fell by seven basis points. Equally, there were no notable movements in the ten-year gilt yield components following the announcement of the general election on 22 May.
For context, the ten-year UK gilt yield moved far more as a result of other recent political events. For example, following the announcement of Liz Truss’s premiership on 6 September 2022, the term premium on the UK ten-year gilt yield rose by 23 basis points in one day. Our first data point following the Truss-Kwarteng ‘mini-budget’ on 23 September 2022 indicates that interest rate expectations jumped by 40 basis points on impact.
We can therefore infer that unlike the market reaction to the political and economic tumult of September 2022, the July 2024 election result is not an event that prompted an immediate change in investors’ expectations of future interest rates nor in their perceptions of risk surrounding the future path of interest rates.
This relatively muted initial reaction in bond markets is also reflected in stock markets (for example, the FTSE all-share index) and exchange rates. A lack of volatility in financial markets – which perhaps signals investor confidence following the Labour win – is a notable result in itself.
That said, it is striking that in the run-up to the election, the term premium on the ten-year UK gilt rose by around 45 basis points, while interest rate expectations fell by around 50 basis points. Since Labour’s electoral win, the term premium on the ten-year UK gilt has continued to rise gradually, and interest rate expectations have also continued to soften. In both cases, these effects have been counteracting, leading to little change in the gilt yield overall.
Given that in the weeks preceding the election, the outcome was perceived by many to be certain, it is possible that markets priced in the impact of a new Labour government (among other factors) ahead of the election date itself.
How does this reaction compare to market movements following recent elections in Europe?
Given the global integration of financial markets, a significant share of the movements observed in ten-year yield curves reflects changes in international risk and uncertainty, as well as monetary policy developments abroad.
The co-movements in term premia estimates in both the UK and European economies suggest there are spillovers of increased risk perceptions following the recent election for the European Parliament (see Figure 2). In the UK, France, Italy and Germany, term premia rose by 26, ten, nine and five basis points, respectively, following the elections.
For the more recent national parliamentary elections in France, our estimates do not indicate that there have been particularly large jumps in the term premium in the aftermath of the first- and second-round elections. Nevertheless, given that at the time of writing a government has yet to be formed, it is difficult to assess fully the markets’ reactions to this event.
Still, what is clear is that the French term premium has drifted significantly from the German term premium since the European-wide elections, reaching a ten-year high in the Franco-German yield spread – the difference between the two yields – on 28 June.
Widening yield spreads in Europe present a risk to financial stability, since countries with higher term premia will face higher borrowing costs. Though we are far from it, this may stoke some fears of another European liquidity crisis – one sparked by a lack of cash or assets that are easily convertible to cash.
In addition, divergent term premia complicate the transmission of interest rate policy. In the Eurozone, this is determined by one authority, the European Central Bank, but applies to all the different Eurozone countries.
Figure 2: Ten-year term premium estimates across countries
Source: NIESR estimates from data by Bank of England, FRED-Federal Reserve Bank of St. Louis and Datastream
Lastly, it is striking that the term premium on the ten-year UK gilt yield rose so steeply in tandem with other European countries’ term premia following the elections for the European Parliament and has yet to recover.
Whether this was an overreaction to perceived risk spillovers from the continent, or indicative of a fundamental shift in investors’ perceptions of risk to UK gilt yields following these elections, will become clearer in time.
Where can I find out more?
Who are the experts on this question?
- Corrado Machiarelli
- Stephen Millard
- Francis Breedon