Market Review 18th May 2026

Everything you need to know, Simplified!

Summary

• UK gilts (UK government bonds) have come under pressure from a confluence of factors, including rising political uncertainty following Labour’s election losses, a deteriorating fiscal outlook, sensitivity to higher global energy prices amid the conflict in the Middle East and persistent inflation against a backdrop of weak growth

• Shorter-dated gilts have been more resilient, with current yields offering a cushion and markets arguably overpricing future rate hikes given the fragile economic outlook

• While downside scenarios highlight the risk of stagnation or recession from sustained yield increases, they underplay stabilising forces including demand destruction and potential policy support

• The Bank of England (BoE) is likely to remain on hold, with any near-term rate hike risking a policy mistake; a sustained further rise in yields appears unlikely without renewed inflation pressure

• In the US, stronger-than-expected inflation and AI-driven investment demand are complicating the disinflation narrative, likely keeping the US Federal Reserve (Fed) on hold for longer than markets anticipate

• This week’s focus is on Federal Open Market Committee (FOMC) minutes, expected to signal a more hawkish and less easing-biased Fed, alongside UK labour and inflation data which should show moderating employment but still-sticky inflation with a likely summer reacceleration.

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Market Review

The UK’s political risk premia

Job security at No. 10 Downing Street is at a low following the election rout for Labour earlier in the month. The Prime Minister is under pressure to step down after his party lost nearly 1,500 council seats across the country. Wes Streeting, Andy Burnham and Angela Raynor are seen as the front runners to challenge Starmer.

The timing for the political turmoil has not been good for the UK’s bond market as global bond yields have coincidentally surged due to the conflict in the Middle East and rising inflation. UK gilts are under pressure on multiple fronts; a rising political risk premium, a deteriorating fiscal backdrop, heightened sensitivity to this global energy shock accompanied by stagnating economic growth and finally a wave of inflation that has seen UK consumers lose a third of their purchasing power since 2021. Gilt yields have risen to their highest levels since 1998 with the 10-year yield closing the week at 5.17%. The pound fell 2.2% against the US dollar last week.

Shorter maturity gilts have been more resilient. The Bloomberg UK 1-5 Year Gilt Index has fallen only -0.5% year-to-date. With yields as high as they are it is hard to envisage a negative return from here on a one-year view. The market is already pricing around three rate hikes by March 2027 which appears pessimistic given the negative growth outlook in the UK. High yields provide a cushion against further losses, while the current pricing leaves scope for a rally should the outlook shift or inflation concerns ease.

The question from here is how high can yields go and what is the impact on the UK economy. Economist Stephen Jen outlines three potential downside scenarios over the next three years, based on both the magnitude and persistence of higher yields. While such frameworks are useful, the transmission of yields into the broader economy is complex and uncertain.

Crucially, these scenarios are deliberately bearish and do not fully account for stabilising forces. They ignore the old adage that the cure to high prices is high prices; high prices destroy demand which in-turn reduces the inflationary impulse facilitating lower bond yields. Policymakers retain tools to support the market if necessary, for one the BoE could halt active Quantitative Tightening – they are already effectively the last central bank still reducing their balance sheet. The Debt Management Office will likely focus on shorter-dated issuance, reducing the government’s borrowing costs and limiting the risks at the most vulnerable point on the yield curve (the long-end).

Our base case is for the BoE to remain on hold for the time being, they may hike rates in Q2 or Q3 once, but this is likely to be a policy error. While the bond market may be vulnerable, we do not believe that a further rise in yields will be particularly persistent given the implications for the economy. Nonetheless it is important to understand the potential economic implications for a further and persistent deterioration in the UK bond market:

Scenario 1: Stagnation

A persistent 1% increase in yields (this is approximately what we have seen since the end of February) results in a prolonged period of stagnant growth. Mortgage rates rise by around 0.75% and remain elevated gradually weighing on the housing market, leading to an approximate 7% decline by 2029. Sterling weakens, with GBP depreciating by around 4%.

Scenario 2: Recession

A persistent 2% yield shock (another >1% rise from here) pushes the economy into recession, shrinking by 3.2% over the three years. Mortgage rates rise by around 1.5%. Housing market weakness becomes more pronounced declining more than 13%. GBP depreciates by 7–8% vs the USD. This scenario would also create significant fiscal stress for the UK Government.

Scenario 3: Deep recession

Under a persistent 3% yield shock, the economy enters a severe recession contracting by more than 5% over three years. Mortgage rates rise by approximately 2.3%, remaining structurally higher throughout the period, while house prices fall close to 20% by the end of 2029. GBP/USD declines toward 1.20 (currently at 1.33). This scenario would also present a major fiscal crisis for the UK Government.

A note on US Input prices, AI and inflation

US Producer Price Index (PPI) inflation jumped from 4% to 6% in April far exceeding economists’ expectations – this surprise cannot be entirely explained by energy prices. Consumer Price Index (CPI) inflation has now been above the Fed’s 2% target for 60 consecutive months. The CPI print also reported higher than expected goods and services (core) inflation.

With the US economy as strong as it has been and financial conditions relatively loose, inflation risks becoming more deeply embedded. Some at the Fed, including its new chairman Kevin Warsh have argued that productivity gains driven by innovation and AI support the case for lowering interest rates; but it is notable today that the surge in investment to build out the infrastructure for AI and the insatiable energy demand for data centres is creating shortages and putting upward pressure on prices.

While it’s true that higher productivity reduces inflation it is also true that interest rates should be more restrictive during periods of economic expansion and that the Fed should not be cutting interest rates without the economic need to do so. While the bar for interest rate hikes remains very high, the Fed may be less inclined to cut interest rates when their main argument for doing so (AI) is having the opposite effect on price trajectory than their models imply – in short – the Fed is on hold for the foreseeable, at least until an obvious price trend emerges.

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The week ahead

FOMC minutes

The FOMC minutes, due Wednesday, will provide further detail on the April meeting - also Jerome Powell’s final meeting as Chair. We expect the minutes to reflect a somewhat more hawkish tone, with several participants leaning toward a more neutral policy stance. As a result, any explicit easing bias in the guidance will likely be scaled back going forward.

The focus will also be on corporate earnings, with results from a major technology company closely tied to AI infrastructure likely to be a key market driver.

UK employment and inflation

UK labour market data, due Tuesday, is expected to show a moderation in job growth in March. Forward-looking indicators suggest labour demand may soften further in the wake of rising energy prices. The unemployment rate is expected to remain stable at 4.9%.

April inflation data is released on Wednesday. Headline CPI is expected to ease to 3%, largely driven by favourable base effects and previous government policy measures. However, inflation is expected to pick up over the summer, potentially rising toward 3.5% by year-end.

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