2025 begins with a bang

The singling out of the UK by financial markets earlier in January was brief and is unlikely to be repeated in 2025. However, the economic outlook remains challenging as inflation is set to remain above target and growth prospects are weak. This backdrop continues to point to the rate cutting cycle proceeding cautiously through this year and into next. 

Global financial markets have been febrile during January. Uncertainty surrounding US policy led to a surge in global government borrowing costs on the week commencing January 6, and it was notable that UK financial markets seemed to be hit especially hard during this period of market volatility. Sterling/dollar and sterling/euro exchange rates saw a notable depreciation, and UK gilt yields rose considerably more in absolute terms than their German and French counterparts. 

Why were UK financial markets singled out at a time of global market turmoil? There has been much debate surrounding this but it would seem that sentiment towards the UK played some kind of role: in particular, the lingering issues associated with the bigger-than-expected pivot in fiscal policy at October 2024’s Budget as well as the subsequent souring of business confidence. 

At the time of market volatility, we said that we thought Opens in a new window the movements in UK financial markets were questionable. Other European markets, especially France, face more troubling economic fundamentals and political risk, and subsequent moves in financial markets proved our scepticism to be justified as spreads between the UK and other major European sovereign debt markets have narrowed once again. Moreover, the increases in UK government (and other Western government) bond yields observed during the week commencing January 6 were effectively reversed the following week, after UK CPI registered at 0.1pp below market expectations and US CPI registered as expected.

We do not expect the UK to be singled out by financial markets again during 2025, but that is not to say the economic outlook is especially positive, as set out in our latest Global Macro Forecast. It would seem that the UK’s fiscal targets may already have been breached. Our calculations suggest that, all other things equal, the increase in borrowing costs compared to the OBR’s conditioning assumptions in October (the average gilt yields in the ten working days in the run up to September 12) has wiped out nearly 85% of Rachel Reeves’ headroom. This, of course, does not even account for the declining outlook since then with, for example, latest data on the labour market suggesting a weakening economy and policy developments in the US making growth prospects even more uncertain. The strong implication is that there will need to be further fiscal consolidation from the UK government at the Spring Statement in March. 

We are also expecting inflation to remain above target through 2025: services inflation is set to remain elevated, wholesale energy prices have risen and retailers will likely pass onto consumers much of the costs associated with higher employer National Insurance contributions and increases to minimum wages. While some wage cooling across the economy should be expected due to weak growth prospects, this probably will not be enough to get inflation back to target this year.

All of this points to a scenario of above-target inflation accompanied by weak growth during 2025, meaning a cautious rate-cutting cycle remains the base case scenario. Note, however, that while medium-term inflation expectations remain a concern for the Monetary Policy Committee, base rates can still fall and remain restrictive for the economy. We expect another rate cut in February, with markets pricing in a roughly 90% chance of it occurring (as of 24.01), and we expect another rate cut before year-end. 

Daniel Mahoney, UK Economist

If anyone was expecting a slow and steady start to 2025, then the reality has been the opposite. We’ve seen a stark rise in bond yields both in the UK and across the Atlantic in the US as the political landscape of 2025 is begins to take shape.

Fiscal policy takes the spotlight

The Lunar Year of the Snake has begun by embarking on a slippery path, and it’s been a painful start to the year for gilt yields. As Daniel talks about in greater detail above, one of the triggers for the UK gilt sell-off was prompted by concerns amongst investors around the sustainability of Chancellor Rachel Reeves’ Budget, and a loss of confidence in her plans to deliver growth and tackle persistent inflation. This saw a hit simultaneously to both UK bond yields and the pound, a move that normally has an inverse relationship (as bond yields rise, typically the pound would follow suit). At the open on January 6 UK 10-year gilt yields pushed through the 4.60% barrier, and continued to climb up to a peak of 4.91% on January 13. This is a far cry from where we were towards the end of last year – up around 70 basis points since the start of December – and the UK 30-year yields hit their highest level since 1998. 

This was partly fuelled by investor expectations that longer term UK borrowing costs are under pressure, and concerns around the ability of the UK government to keep national debt under wraps to curb inflation. However, if we contrast this with the release of UK CPI figures on January 15, we saw swap rates fall. The inflation readings surprised to the downside, with the year-on-year CPI figure for December posted at 2.5%, compared to the expected reading of 2.6%. This was partly driven by a drop in airfares and hotels, but this is anticipated by many to reverse in the January reading next month, so only offers temporary relief. The RPI reading came in at 3.5% year-on-year compared to the expected 3.8%, which could provide a level of respite the government is looking for to rising gilt yields. The services element of inflation was markedly lower at 4.4% than the 5% reading from November. This has been an area of particular focus for the Bank of England given it has remained a stickier inflation component, and has been one of the barriers to the MPC cutting base rate further last year.

Deputy Governor of the Bank of England Sarah Breeden downplayed the spiking gilt yields and fall in the pound, saying that the market moves are “orderly”, with signs of cooling economic activity and weakening wage growth. Her comments are indicative of a reluctance of the Bank of England to step in as it did after the 2022 Truss mini-Budget, particularly as Ms Breeden rarely delivers speeches which directly discuss monetary policy. 

The 10-year gilt yield dropped 8bps to around 4.80% on the inflation reading, and the spread between US and UK 10-year bond yields narrowed by 5bps. The narrowing of the spread was as a result of the weaker inflation print, and reduced growth prospects in the UK. The narrowing in spreads also is reflective that UK and US monetary policy is converging – currently the US benchmark rate is 25bps lower than the UK, and this indicates the UK may head towards another rate cut.

Traders have since adjusted their bets to move to over a 90% chance of a cut at the February meeting, putting a rate cut on the cards for Q1 this year, with the next cut not fully priced in until summer. We are looking at only two rate cuts fully priced in until the end of 2025, with markets expecting Base Rate to be in the region of 4-4.25% at the end of the year. This is a far cry from where we were last year, and if we compare this to pre-Budget in mid-October we were eyeing up a rate cut every quarter of 2025. Higher for longer is once again becoming the theme for this year’s outlook. 

Jasmine Crabb, Capital Markets