Kevin Thozet: ‘Higher bond yields feed into higher bond yields’

UK Budget 2026 – Caught in the fiscal loop

The UK needs high yields to attract capital, writes Kevin Thozet in an additional insight to the above video, but it can ill afford their rising cost

The UK fiscal outlook looks less politically uncertain than it did a few months ago – though no less constrained. Labour’s weak approval ratings make an early election unlikely, while the Burnham government remains tied to Starmer’s pledge not to raise the main tax rates. That leaves limited room for expensive policy ambitions for now.

The debt story is less of an immediate concern – all eyes are currently on the continent – as public debt to GDP has broadly stabilised below the 100% mark, while fiscal rules and reinforced market scrutiny impose a degree of discipline on the primary balance.

The main problem is that higher rates are steadily eating into that room for manoeuvre. Roughly a third of the available fiscal headroom has already been absorbed by higher borrowing costs, and any further rise in gilt yields mechanically tightens the leeway and further complicates the Budget’s arithmetic.

This matters all the more because, despite the government balance improving, it remains negative and the UK still runs a ‘twin deficit’. A persistent current-account deficit means the economy must continue to attract foreign capital to finance itself.

That capital can come through gilts, equities or private investment, but the basic constraint is the same: capital does not come for free, and UK assets need to offer a sufficiently attractive return to attract capital, which – all else being equal – means higher yields.

That is where the vicious circle starts. Higher bond yields help attract the foreign capital the UK needs, but they also raise the government’s interest bill, eroding fiscal headroom and leaving even less space for spending or tax relief. The more expensive it becomes to fund the external deficit, the more difficult it becomes to run an expansionary fiscal policy.

The current account is not likely to offer much relief either. It is expected to remain in deficit for longer – partly because the UK remains heavily dependent on imported energy, including gas from Norway and the US. That weakens the external balance and reinforces the need for continued capital inflows.

This Budget therefore sits at the intersection of three constraints: fiscal rules, higher-for-longer funding costs and an economy that still depends on foreign capital. So the circle closes: as external deficits require capital inflows, capital inflows require attractive yields, higher yields worsen the fiscal position – and a tighter fiscal position leaves less room to support growth.

What gives you pause for thought around the current economic climate?

I would say the most worrying factor is rising bond yields – and there are two main reasons for this. I mean, bond yields can go up for good reasons – for example, because economic growth is there. Inflation can be a good reason as well because it is a scenario of economic growth. Bond yields can also be going up for bad reasons, however – and that is typically what is happening these days in, say, France.

The phrase coined some decades ago to describe this is ‘bond vigilantism’. And so fixed income markets are very much concerned and looking at what is happening in France, and for very good reasons – or very bad reasons. French fundamentals are quite poor – slower growth, high debt, a high deficit, the cost of debt doubling every five years and very little prospect of a better outlook going forward.

Now, today it is France – but tomorrow it could be Belgium. Yesterday it was the UK and, again, tomorrow it could be, say, Japan. So I would say that is the most concerning factor – and the reason why it is the most concerning factor is because we know that, let’s say, political deadlines and fiscal orthodoxy generally do not go hand-in-hand.

And we have four major European elections, over the coming year, within the four largest economies. We will have France, as I mentioned, as well as Spain, Italy and Germany with its ‘landers’ [regional] elections – and, in fact, a fifth one with Poland. So the fiscal outlook is not looking great and higher bond yields cause what we call ‘reflexivity’ – that is to say, higher bond yields feed into higher bond yields.

How would you translate all that into practical ideas for investors?

I would say something akin to ‘higher for longer’ would be one idea. A second one is that inflation is here to stay – and it is not just linked to what is happening or not happening in Hormuz or in Yemen or in Ukraine. That would be the second key component. And so what are the consequences for financial markets?

One is – be wary on, let’s say, nominal government bonds issued by those well-rated issuers of France today, Belgium tomorrow, maybe the UK after that – or the US for that matter. That is the first point. The second one is that I think inflation-linked bonds could be very good instruments to navigate this environment.

That is because they can absorb a demand shock – as they have a duration component embedded into them – but they can also absorb a supply shock because they have inflation expectations embedded into them. And the good news is that inflation expectations two, three, four or five years out are, in fact, quite cheap. Markets are only looking at the volatility of higher energy costs on short-term inflation expectations. So that would be a second consequence.

And the third one is to be looking at more than just AI – I would say there is more to life than that. AI is a very good trade but things can happen elsewhere – and, if we are saying ‘higher for longer’, that would mean being wary about valuation and I would tend to say that emerging markets are very well-suited, or very well-positioned in this environment.

They benefit from the commodities boom – notably, Latin America. And they benefit from the capex boom because they are building all those ‘picks and shovels’ businesses – notably, Taiwan and Korea – and they tend to come at much cheaper valuations. And while that is very true on the equity side, I would also say local currency emerging markets fixed income could be another area to consider.