Views from the LDI desk – July 2025

Gilt Market Volatility: Political Risk Reasserts Itself

Political Backdrop: Welfare Climbdown Exposes Fractures

The gilt market has reacted sharply to renewed political instability. A climbdown on key welfare reforms, designed to contain spending, has triggered questions about the government’s fiscal direction. This was compounded by Prime Minister Keir Starmer’s conspicuous failure at PMQs to confirm his support for Chancellor Reeves, stoking concerns about internal divisions and undermining fiscal credibility.

With the market anticipating a growing risk around a change in the Treasury with the related potential to change fiscal rules, long dated yields experienced a sharp move higher, with the day on day move up there with the biggest we’ve seen since 2022. However, with Chancellor Reeves later receiving ‘Full Support’ from the PM and still in seat the next day, the market has begun to recover some of the ground lost.

However, this goes to indicate again just how much a hair trigger the gilt market continues to operate under. The market still hasn’t fully recovered its poise since 2022 and the slightest hint of political turmoil can drive spikes in volatility due to the intense scrutiny and focus put on set piece fiscal events and fiscal headroom. That said the moves have not yet returned us to the highs seen in April post the tariff announcements.

Autumn Budget in Focus: Productivity and Fiscal Headroom

There was already going to be significant focus on the Autumn Budget, but this will now only be growing. The Governments climbdown on welfare reforms follows on from a U-turn on the removal of the winter fuel allowance combined with expectations that reforms to the non-domiciled tax regime may not raise as much revenue as hoped means the government is already likely to be facing a shortfall vs. their current fiscal rules.

This is unlikely to be helped by potential changes to assumptions made by the Office for Budget Responsibility (OBR), which has acknowledged in its latest report that its productivity growth forecasts may have to be reduced due to being too optimistic.

As we stand the Government has limited options

• Tax rises – any increase in the 3 main taxes (Income / VAT / National Insurance) fall foul of Labour’s manifesto pledges of not raising taxes on working people. They could look at more modest tax increases e.g. pension tax reform / stamp duty etc but again likely to be politically unpopular. There are small tweaks that can be made without breaking manifesto pledges, for example extending the freeze in personal tax thresholds for 2028 but is unlikely to be sufficient.
• Fiscal rules – both Reeves and Starmer remain committed to the fiscal rules and to all intents and purposes they are set in stone. One potential tweak could be a rolling 3-year commitment but again this is politically very unstable.
• Potential for cuts to public sector spending but as we’ve seen from the last few days even though Labour have a significant majority there are plenty of MPs that are willing to rebel and political will to push these reforms through appears to be lacking. Spending already looks consolidated in the back-end and, and with a general election currently likely in 2029 even the current spending plans may need to be revised upwards.

Supply Dynamics: Summer Relief, but Only Briefly

The summer brings temporary relief on supply, with a seasonal drop in issuance and coupon reinvestment flows providing a technical tailwind. July in particular looks supportive, with limited syndication supply. But this is a pause, not a pivot. The second half of the year brings heavier supply. So while the July technical have historically been favourable for gilts as supply often is dialled back and re-investment supports the market, this support is likely to be short lived.

Strategic View: Short-Term Calm, Long-Term Volatility

We see near-term support for gilts through July as technicals and low supply align, assuming Reeves Mansion House Speech on the 15^th July does not bring anything unexpected.

However, we caution clients against extrapolating this into the autumn. The political calendar is heating up, the fiscal narrative remains unstable, and gilt investors are clearly on edge. We expect continued volatility, particularly around Budget events and party conference season.

Reeves may well survive for the coming months as the Prime Minister and his advisors will have been alarmed by the sharp reaction in the gilt markets as speculation grew on her future. For a time this may bring an element of stability, but the fiscal calculus remains what it is and difficult decisions need to be made.

For this reason, strategically we continue to favour a modest underweight in hedge ratios to provide a tail risk hedge against the asymmetric risk of declining collateral resilience in a scenario in which gilt yields materially underperform. This might be driven by a political crisis such as a change in Chancellor, change in fiscal rules or even a leadership challenge as the Labour party attempts to work through the fiscal policy log jam and competing views of different parts of the party, despite their large majority. The inability to pass the welfare reforms this week without a material watering down has in our view increased the risk of these outcomes.

The opinions expressed are as of July 2025 and are subject to change at any time due to changes in market or economic conditions. The above descriptions are meant to be illustrative. There is no guarantee that any forecasts made will come to pass.

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