3. Bond markets: beware of shark-infested waters

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3. Bond markets: Beware of shark-infested waters

Global economics and policy trends

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3. Bond markets: Beware of shark-infested waters

What we said
We warned that sovereign bond markets in certain developed economies were vulnerable. The UK and France were highlighted as particularly exposed given questions over fiscal sustainability against a backdrop of rising government debt.

How it has played out
Fixed income performance has been mixed so far in 2026, with sovereign bonds delivering flat-to-negative returns across most developed markets. UK Gilts have posted year‑to‑date losses of around 1.2%, underperforming the Global Aggregate index, which has been broadly flat.2

Sharks are circling the UK
Gilt yields have spiked as markets question the sustainability of UK fiscal policy in the context of weak activity and the negative impact of the Middle East war. Higher energy costs are squeezing consumers and may force the Bank of England to tighten policy later in the year to contain inflation.

Domestic politics have added to the pressure. Support for Prime Minister Keir Starmer has faded after poor local election results in early May, compounding a decline in approval ratings driven by low growth, persistent inflation and rising unemployment.

The 30‑year Gilt yield surged to 5.8% on 12 May 2026, the highest level in more than 25 years, as a political crisis threatened Starmer’s position and cast doubt on Chancellor Reeves’s fiscal plans. Yields across the curve now stand above those seen during the Liz Truss mini‑budget crisis in 2022 (Figure 3). This time, however, the external backdrop – notably the war in the Middle East – risks amplifying the UK’s economic and financial vulnerabilities.

3-3-3 objective not yet reached
In the US, the conflict with Iran has triggered a repricing of short‑term rate expectations and a flattening of the yield curve. The 2‑year Treasury yield has risen 48 bps year‑to‑date, while the long end has moved up by 14 bps. Bessent’s 3‑3‑3 objective – 3% real GDP growth, a 3% budget deficit and a 3 million barrels‑per‑day increase in oil production – is likely to take longer to achieve than initially planned.

The IMF now expects US GDP growth of 2.3% in 2026, while the fiscal deficit is projected to exceed 7% of GDP. The US Energy Information Administration forecasts oil production at around 13.6 million barrels per day in 2026, unchanged from 2025 production, short of the 3‑3‑3 target.

Outlook for H2 2026
Investors should continue to tread carefully in sovereign bond markets. While gross debt in economies such as the UK is expected to stabilise over the next five years, short‑term domestic challenges and a difficult external environment could derail fiscal plans and trigger leadership changes.

In the US, efforts to stabilise the debt trajectory are unlikely to materialise against the backdrop of external conflict and mid‑term elections later in the year. Overall, the environment favours countries with stronger fiscal positions and clearer capacity to service their debt.

Action for investors:

  • Prioritise sovereigns and strong balance sheets: Focus on countries with robust public finances and credible debt‑repayment capacity. Net foreign assets can provide a useful guide to long‑term debt sustainability.
  • Be selective in higher‑risk issuers: Treat UK Gilts and other fiscally stretched sovereigns as trading rather than core holdings, given elevated political and policy risk.
  • Consider resilient credits in stressed regions: Saudi bonds, for example, have continued to perform despite the war on their doorstep, underlining the importance of balance‑sheet strength and policy credibility.

2 Source: LSEG Data & Analytics and EFG. As at 31 May 2026.

3. Bond markets: Beware of shark-infested waters

There are several markets – notably France and the UK – for which fiscal sustainability will be questioned in 2026. Pledges to bring government finances under control may pacify the sharks for a while but when confidence evaporates bond markets will look vulnerable once again. This may cause problems for government stability in some parts of the world.

Can the US change its debt path?
In the US, concern about debt sustainability is demonstrated by the latest projections which show US government debt rising from 100% of GDP in 2025 to 119% by 2035 (Figure 4) and continuing upwards to 156% in 2055, although developments over such a long period are subject to a great deal of uncertainty. In 2026, the sharks may be dissuaded from attacking the US bond market if the revenues generated from tariffs are sufficient to alleviate fears about debt sustainability. Most estimates forecast such revenues to be in the order of USD400bn per year.

Over the long-term, the extent to which Scott Bessent’s “3-3-3” plan (Theme 1) is successful will be key. It could markedly change the debt path, preventing an upward trend. In the late 1990s and early 2000s, the debt level fell rapidly and unexpectedly to 31% of GDP, primarily due to the strength of tax revenues and improving productivity. There was active discussion at the time about abandoning 30-year government bond issuance, regarding such debt as no longer necessary to finance the deficit. Although possible, such an extreme outcome seems unlikely to us. The more realistic outlook for 2026 is that the stabilisation in the level of debt expected under the Bessent plan as well as improving productivity due to AI implementation should be enough to alleviate fears about US debt sustainability.

Europe – sharks are circling
In Europe, concerns about fiscal sustainability will not be so easily quelled. “France could be the new Greece” is a concern held by some, but that comparison lacks credibility. France, unlike Greece in 2009–10, does not rely on foreign capital inflows to finance its current account deficit; economic growth remains positive; the European Central Bank has better procedures in place for averting a crisis; and the French bond market remains active and liquid. Yet President Macron has been through five prime ministers in the three years of his second term and none have been able to pass a budget to put fiscal policy on a sustainable track.  

Support for an individual bond market could come from the European Central Bank, which has, in the past, modified its operating procedures to allow such action.6

Similarly, the credibility of the UK’s efforts to meet its self-imposed debt restrictions is low and could be tested in 2026. Parallels with the “Liz Truss moment” in 2022 are often drawn. That episode – when an unfunded reduction in taxation, which had not been assessed by the independent Office for Budget Responsibility was announced – led to a sharp fall in sterling and the gilt market. While the current UK government faces many challenges that will likely put pressure on sterling and gilts, for the time being we do not foresee a repeat of the sharp and sudden dislocation

Action for investors:

  • If bond yields have already discounted the worst, look to take advantage of high yields in the US, France and UK. This could be a risky strategy, especially for longer-duration bonds which have a high sensitivity to changing expectations of fiscal and interest rate trends.
  • The absolute level of short-term US yields is still high and it provides a safer habitat for nervous investors as sharks circle.
  • Focus should be on countries that have adequate finances to be able to pay off their debts. Net Foreign Assets (NFA) as a measure could provide a guide to long term debt sustainability.

6 In the past the European Central Bank has conducted various programs to support what they described as “disorderly market dynamics”. This was the case of the Transmission Protection Instrument (TPI) in 2022, the Asset Purchase Programme (APP) in 2015, and the Pandemic Emergency Purchase Programme (PEPP) in 2020.

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