The central case for the UK bond market in 2026 is not one of renewed stress. If inflation continues to ease and Bank Rate is reduced gradually, gilt yields might well be expected to drift lower over the year. While that is the central case, there is clearly a significant risk that we could see heightened volatility in the gilt yields as the year progresses, which could have the potential to knock the economy off course.

There is no shortage of potential shocks. One obvious risk is domestic political instability. A leadership change around the May local elections that weakened confidence in the fiscal framework would almost certainly jolt the gilt market. Another is that inflation proves more stubborn than expected, forcing markets to reassess the likely path of interest rates.

In this blog, however, I focus on a different possibility: that gilt markets come under pressure not because of domestic policy mistakes, but as a result of contagion from developments elsewhere – in particular, the US Treasury market. In an integrated global bond market, sharp moves in US yields can transmit quickly across borders, tightening financial conditions even in economies whose fiscal fundamentals are unchanged.

In what follows, I set out a stylised risk scenario for gilts based on this idea. The scenario is not a forecast. Rather, it is an analytical device designed to illustrate how such a shock could arise, how it might propagate, and how the appropriate policy response could change as conditions evolve – from an orderly repricing to a full-blown financial stability event.

A Risk Scenario for Gilts
Part 1: The Initial Shock

By early 2026, headline inflation in both the United States and the United Kingdom has fallen from its peak, but underlying inflationary pressures remain persistent. Wage growth is elevated, particularly in services, and progress back to target is proving slower than many had expected. Bond markets have adjusted to this environment: at the start of the year, UK 10-year gilt yields stand at around 4.4 per cent, while US 10-year Treasury yields are around 4.2 per cent.

In early February, the President announces his nominee for the next Chair of the Federal Reserve. The chosen nominee is well known for arguing that the economy’s neutral real rate of interest, r*, has fallen, and that monetary policy should be eased to support economic growth. In early remarks, the nominee emphasises the risks of keeping policy too restrictive for too long and plays down the likelihood that inflationary pressures could resurface.

The market reaction is uneasy. Over the course of the following weeks, US Treasury yields increase; by late February 10-year yields are around 30 basis points higher, driven primarily by wider term premia. There is also a notable increase in breakeven inflation rates, particularly at longer horizons. Market liquidity deteriorates, especially in longer-dated securities, and volatility picks up. The move spreads into other advanced economy bond markets. Gilt yields rise, particularly at the long end of the curve, approaching levels last seen in autumn 2025.

In the weeks that follow, markets remain functional, but conditions are more fragile. Yields are higher, volatility has increased, and sensitivity to further news is elevated. When the nominee is confirmed by the Senate in May and formally takes office, attention turns to the first policy signals from the reconstituted Federal Open Market Committee. At its initial meeting under the new Chair, the Fed surprises markets by delivering a 50-basis point cut in the federal funds rate and signals that a further 100 basis points of easing is likely over the year ahead, citing tightening financial conditions and downside risks to growth. Investors interpret the announcement as signalling a shift in the Fed’s tolerance for inflation.

The reaction in bond markets is immediate and adverse. Longer-term yields rise sharply as investors reassess the balance between inflation risks and policy credibility. The yield curve steepens markedly. Over the course of a week, 30-year Treasury yields increase by around 100 basis points. Breakeven inflation rates rise further, and volatility spikes.

The dislocation does not remain confined to the United States. Global bond markets reprice as investors reassess long-run inflation and policy risks. In the UK, gilt yields rise sharply, again led by the long end of the curve. Thirty-year yields move by a substantial amount in a short period, tightening financial conditions materially. The Debt Management Office responds by adjusting the composition of issuance, tilting towards shorter maturities and index-linked gilts in an effort to limit the immediate fiscal impact. But this does little to arrest the broader repricing.

Commentary quickly turns to the implications for the UK economy and public finances. Higher yields and a weaker growth outlook worsen the (already precarious) fiscal arithmetic, raising questions about the path of debt even though the initial shock had nothing to do with UK fiscal policy. Financial conditions tighten further, reinforcing the downturn.

Part 2: The Bank of England Response

The Monetary Policy Committee (MPC) meets in mid-June as scheduled. Views diverge on the appropriate response. One perspective is that the rise in long-term yields represents an exogenous tightening of financial conditions equivalent to a material increase in Bank Rate. On this view, maintaining the existing stance risks pushing demand below the path consistent with returning inflation sustainably to target. A lower path for Bank Rate could therefore be justified.

Others are more cautious. Inflation remains above target, wage growth is still elevated, and the rise in yields is concentrated at the long end of the curve. From this perspective, easing policy risks compounding concerns about inflation credibility at a moment when global markets are already reassessing central bank resolve. Some also argue that the fiscal consequences of higher long-term yields – particularly higher debt interest costs – are not primarily a matter for monetary policy. 

There is also a discussion about whether asset purchases should resume. Members of the Bank’s executive express concern that doing so would reinforce an expectation that has developed amongst some market participants that the central bank will step in quickly whenever bond market volatility arises. They note that conditions differ materially from those following the Truss-Kwarteng mini-Budget, when pension funds became forced sellers and the gilt market entered a clear dysfunctional feedback loop.   

For the time being, the Bank opts for caution. Bank Rate is left unchanged.  Communication emphasises data dependence and the distinction between global financial conditions and the domestic inflation outlook. Direct intervention in gilt markets is explicitly ruled out. That judgement, however, rests on the assumption that the tightening in financial conditions remains orderly.

Part 3: Financial Stability Problems Emerge

The assumption is tested by a renewed bout of global risk aversion triggered by a sudden escalation in geopolitical tensions. Investors hoard cash and reduce exposures across markets. Short-term funding rates rise and balance sheet constraints bind more tightly.

In US Treasury markets, higher volatility and the scramble for liquidity place acute pressure on leveraged trading strategies. Cash–futures basis positions, already weakened by the earlier rise in yields, unwind at scale. Futures margins increase sharply, repo funding becomes more expensive and less available, and hedge funds are forced to sell cash bonds to meet margin demands. Dealer intermediation capacity is quickly overwhelmed and market liquidity deteriorates further.

The stress propagates across borders. Gilt markets, already fragile, are hit by the same dynamics. Leveraged investors running similar relative-value strategies in UK rates reduce exposures, while global funds retrench simultaneously. At the same time, open-ended bond funds experience a marked increase in redemptions as investors respond to falling prices and heightened uncertainty. To meet outflows, funds sell gilts, adding to downward pressure on prices.

An adverse feedback loop takes hold. Forced selling pushes yields higher, triggering further margin calls and redemptions. Repo markets tighten sharply, initial margins rise, and the pool of willing buyers shrinks. Over the next three days, gilt yields rise by a further 50 basis points. Price action becomes increasingly disconnected from assessments of long-run fundamentals. Market participants begin to describe conditions as dysfunctional.

On a Wednesday in late June, the Bank of England convenes an emergency meeting involving both the FPC and MPC. It announces a response package focusing on liquidity provision. Repo operations for banks are expanded, with term funding offered against a broader range of collateral to prevent a withdrawal of intermediation. Enhanced liquidity support for non-banks is also announced, extending access to systemically important counterparties central to gilt market functioning. In parallel, the FPC recommends temporary regulatory relief, exempting gilt exposures from the leverage ratio to allow banks to continue providing repo financing.

These measures help at the margin, but they do not restore confidence. Large non-bank investors who had become the marginal buyers of gilts remain focused on preserving liquidity and reducing risk, not on stabilising prices. On the Thursday and Friday of that week, yields push higher still and market depth remains impaired.

Over the weekend, attention at the Bank turns to the possibility of resuming asset purchases, explicitly framed as a market-functioning intervention rather than a change in the stance of monetary policy. Senior officials note how effective such purchases were in arresting forced selling and restoring liquidity following the Truss-Kwarteng mini-Budget in 2022.  

The context is less favourable, however. Sterling has weakened as markets reassess the UK’s exposure to global inflation and credibility shocks. Against that backdrop, some within the Bank worry that renewed gilt purchases risk being interpreted as validation of higher long-term inflation or as an implicit attempt to cap government borrowing costs. The longer any intervention persists, the harder it becomes to maintain the distinction between restoring market functioning and easing financial conditions.

On Monday morning, the Bank announces a time-limited, two-week programme of gilt purchases, designed to restore market function. While the intervention brings down long-term yields and improves market liquidity, sterling falls further and breakeven inflation rates edge higher, sharpening the underlying policy dilemma. 

Takeaway Thoughts from the Scenario

The scenario illustrates how easily a sovereign bond market shock could emerge in a world of sticky inflation, high public debt and globally integrated capital markets. The initial disturbance need not originate in the UK, nor reflect any deterioration in domestic fiscal discipline. A reassessment of inflation risks or policy credibility in the United States can tighten financial conditions globally, pushing up gilt yields and weakening the UK outlook even before any domestic policy response is considered.

The analysis also highlights how quickly a macro-financial repricing can morph into a financial stability problem once it interacts with leverage, liquidity transformation and market structure. In today’s gilt market, non-bank investors play a central role in absorbing issuance and providing liquidity. That makes the system more sensitive to margin dynamics, repo market conditions and redemption behaviour than in the past. This risk has featured prominently in all recent financial stability assessments by major central banks.

Perhaps the most interesting lesson concerns the policy reaction. The scenario raises difficult questions about whether the Bank of England would – or should – intervene earlier, during the phase when financial conditions are tightening but markets remain orderly. Acting at that stage might limit the risk of a disorderly unwind. But it would also risk reinforcing expectations that central bank asset purchases are a standing backstop against rising long-term yields, even when inflation is above target and the shock originates abroad.

Once financial stability concerns crystallise, the case for intervention becomes clearer, and the evidence on the effectiveness of asset purchases aimed at restoring market functioning is encouraging. But there remain unresolved questions. What are the practical limits of such asset purchases when the shock is imported rather than domestic? How far can the Bank lean against market dysfunction without undermining its inflation-fighting credibility? Where is the boundary between such interventions and outright fiscal dominance? And how would the calculus change if a large, leveraged hedge fund were to fail outright rather than unwind in an orderly fashion?

Let’s hope these are not questions that demand urgent answers in the year ahead.

For more on these issues, see:

I am grateful to Simon Nixon for posing the question of whether the Bank would intervene in a gilt market crisis absent a financial stability amplifier.