UK assets’ strong performance has been a feature of the early days of 2026. And while the FTSE 100’s continued prowess is unlikely to be a vote of confidence in the domestic economy, a more plausible case for improved sentiment can be made using the gilt market.
After a rocky 2025, particularly in the summer months when speculation mounted over the chancellor’s future, the early days of the new year hint at a change in attitude.
Concerns over the fiscal position, government policy, economic growth, inflation and interest rates all have a bearing on gilt yields, as do moves in their US Treasury equivalents. Last year, it was inflation and policy concerns that won out, even as the Bank of England (BoE) cut base rates four times. Now, with price growth finally having dipped and major fiscal announcements deemed unlikely until the end of the year, the focus is on potential positive catalysts.
Goldman Sachs has gone as far as predicting that 10-year gilt yields (which move inversely to prices) will drop from 4.5 per cent to 4 per cent this year. That represents one of the bank’s highest-conviction forecasts for 2026, and would equate to a total return of 9.6 per cent – well in advance of estimated gains for other government bonds, and not far off the 12 per cent rise the bank sees for the S&P 500.
Ten-year yields have duly fallen to 4.4 per cent over the past fortnight. This doesn’t sound like much but, as always with the bond market, it’s relative performance that matters. German bund yields have also dropped this year, but to a lesser extent; Japanese yields have moved in the opposite direction on rumours (now confirmed) of a snap election; US Treasury yields have also crept higher, albeit the administration’s latest attack on the Federal Reserve did not move the needle this week.
The drivers of this improved sentiment are arguably threefold. First is the belief that the BoE will cut rates more than expected this year. This isn’t wholly good news, given that easing will be in part based on a weakening economy. But with UK base rates currently at 3.75 per cent, compared with the Eurozone’s 2 per cent, the BoE has more room for manoeuvre than its European counterparts. Markets are currently pricing in two UK cuts this year, and the chances of at least one more are on the increase.
Second is the fact that the Debt Management Office (DMO), conscious of the fact that there are fewer buyers of long-dated gilts nowadays, has reduced the amount of these bonds it intends to sell in the first quarter.
Third, and most speculative, is the suggestion that the unsavoury notion of a ‘moron premium’, coined by TS Lombard economist Dario Perkins in 2022 to describe the extra amount that erratic UK governments must pay on their debt, is starting to recede.
The jury is still out on that, and there are other risks to this feel-good scenario. An increase in inflation is one. If price growth were to increase at the same time as employment continues to weaken, the BoE would feel it could not ease policy much further, and stagflationary concerns would reignite.
Yet some think inflation could fall more than investors currently expect. December’s consumer price index inflation reading, due to be published next Wednesday, is expected to tick up from November’s 3.2 per cent rate. Yet Capital Economics said this week it thinks price growth will fall back to the 2 per cent target in April, partly because of lower energy bills, and also because 2025 hikes to water, education and rail prices won’t be repeated. Capital, like Goldman, expects three cuts by the BoE this year.
One other distinctly reasonable concern, however, is that May’s local government elections will increase the chances of the prime minister and the chancellor being replaced. Talk of a leadership challenge has already resurfaced this month.
Nor have long-standing structural weaknesses relating to the UK debt stock gone away. The DMO’s decision to rein in issuance looks helpful, but demand from defined-benefit pension funds – historically one of the biggest buyers of long-dated bonds – is not coming back, and must ultimately be replaced in some form. The UK also continues to have a lot of inflation-linked debt, which means any resurgence in price growth, be it driven by domestic or international factors, would be particularly painful.
As all this implies, the current state of play is contingent rather than definitive. We are still far from a Goldilocks scenario, so named for an economic environment that is deemed to be ‘just right’ rather than too hot or too cold. But UK bondholders, used to things overheating in recent years, are discovering that the temperature is cooling nicely amid continued global upheaval.