The UK bond market has been on a rollercoaster ride, with borrowing costs surging back towards levels seen after the government's recent budget announcement. This volatility reflects lingering investor anxiety over the government's fiscal expansion plans and the looming US presidential election, which is adding to the market's uncertainty.

Navigating the Choppy Waters of the UK Bond Market

Soaring Borrowing Costs and Weakening Demand

The yield on 10-year gilts has climbed as high as 6 basis points, nearing the one-year high reached last week. Short-dated rates have also risen, outpacing their US and euro-area counterparts. Notably, demand for new bonds in a recent auction was the weakest in almost a year, signaling growing investor caution.Bond investors are concerned that the government's plans to increase borrowing to fund investments will stoke inflation, limiting the Bank of England's ability to cut interest rates. The sell-off in gilts accelerated after the budget announcement and has continued amid broader market anxiety over the US election outcome."It's a combination of US election uncertainty and concern about the budget," explained Mark Nash, head of fixed income alternatives at Jupiter Asset Management. "There seems to be some fear in the market that the budget won't work."

Pension Funds' Shifting Role in the UK Bond Market

Giles Gale, a strategist at UBS Group AG, points to a structural shift in the UK bond market, with pension funds buying fewer long-dated gilts. These funds were once major buyers, but their absence has yet to be filled, contributing to the market's vulnerability.The latest auction of new 10-year gilts attracted the weakest demand since December, with bids totaling just 2.81 times the £3.75 billion ($4.9 billion) on offer. This contrasts with the solid investor interest seen in recent sales, including a 30-year green note offer last week.These developments suggest that investors are increasingly wary of any hint of government largess when it comes to deficit spending. As Wall Street veteran Ed Yardeni warned, "it's a conceivable scenario that the bond vigilantes are definitely mounting up," referring to the risks of increased spending in both the UK and the US.

The Looming US Election and its Potential Impact

The losses in the UK bond market have been compounded by uncertainty surrounding the US presidential election. Many investors are adopting a wait-and-see approach, unwilling to make significant moves until the outcome is clear.The concern is that government spending in the US will increase under either Donald Trump or Kamala Harris, though the risks are perceived to be higher under a Trump presidency. This would further lift borrowing costs, with the potential for global spillovers."Market focus is now squarely the US election, given the close race and potential market ramifications," said Neil Mehta, portfolio manager at RBC BlueBay Asset Management. "Gilts are now taking a back seat."The upcoming US election will also set the stage for the Bank of England's policy meeting on Thursday. Markets expect a quarter-point cut, but have trimmed the scope for further reductions to account for the government's looser fiscal policy. Investors now see between two and three additional reductions by the end of next year, compared to four before the budget."The fiscal loosening makes it harder for the BOE to accelerate cuts and to keep up with the pace of easing elsewhere," Citigroup strategists including Jamie Searle wrote in a note. This suggests that gilts are unlikely to rebound from their recent losses anytime soon.