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Questions around interest rate cuts with two big events on the horizon

The economist's corner

All eyes on 30 October

Knocks to consumer confidence and a possible reaction from bond investors relating to UK Budget concerns should be temporary. 

  • In any case, heightened tensions in the Middle East as well as policy changes arising from the US election may end up having a far more material impact on the UK economic outlook. 
  • Our base-case scenario for interest rates to gradually fall to 3% by mid-2026 remains. 

We pointed out in the last Rate Wrap that UK consumer confidence took a dip in September as worries associated with the upcoming Budget have come to the fore. Early October also saw a spike in UK government borrowing costs, which some commentators interpreted as bond markets expressing concerns about reports that Chancellor Reeves is set to change her fiscal rules.

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Since then, gilt yields dropped again but it is worth briefly looking at what prompted the early October jump in yields. The first thing to emphasise is that the increase in gilt yields will likely, in large part, be attributable to a change in inflation expectations following a strong US payrolls report. Moreover, the element of the increase that is down to any concerns related to prospective changes to fiscal rules should be short-lived. The proposed change to the debt rule would give Chancellor Reeves more flexibility on capital expenditure but it would not give more scope to increase current spending, so this should not have a long-term impact on the way that financial markets perceive the UK’s long-run fiscal sustainability.

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Citi analysts currently estimate a central scenario of £17bn of headroom against the target of running a current budget surplus. However, it must be stressed that this assumes “status quo spending” that would mean that there are real-terms cuts to various government departments, something that the Chancellor will want to avoid. So it seems inevitable that tax rises are coming. It is pretty clear what the Chancellor will not do at the Budget: changes to income tax rates, employee National Insurance Contributions, VAT, corporation tax rates and pensions tax relief have all been effectively ruled out. We may see changes to employer’s national insurance contributions, capital gains tax, inheritance tax and various duties, but we of course can’t be sure until 30 October.

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The Budget may end up having an impact on the UK economic outlook – either to the downside or the upside – but international events over the next few weeks could end up being far more influential. Heightened tensions in the Middle East have the potential to lead to a wider regional war, something we are not envisaging at the moment but nonetheless would have the potential to cause major disruption to global energy markets. And, of course, the US election comes just one week after the UK Budget, which could lead to a ramping up of trade restrictions between the US and China. The world’s two largest economies would no doubt bear the greatest proportional impact from this, but open economies such as the UK would also suffer. There are, however, nuances: for example, the direct impacts to the UK would be mitigated if any global increase in tariffs were restricted to goods: around two thirds of UK exports to the US are services.  

It is a difficult environment to make projections but the economic forecasts we laid out in the latest Global Macro Forecast remain our “base-case scenario”. This includes our projections for UK interest rates. The next Monetary Policy Committee (MPC) interest rate decision will be on 7 November, the same date as the US Federal Reserve and Sweden’s Riksbank as it happens, and it would seem almost certain that a further cut in rates will take place. But we continue to believe that the pace of interest rate reduction from thereon will be cautious, with our base-case view being that rates will fall at a gradual pace to 3% by the middle of 2026. While the Bank of England governor has talked about the prospect of more aggressive rate cuts, it is notable that other MPC members such as the Chief Economist Huw Pill continue to remain concerned that structural changes in the UK economy may require monetary policy to be restrictive for longer. 

Daniel Mahoney, UK Economist

A view from the dealing desk

  • Data shows UK service sector prices are cooling, taking the heat out of inflation and opening the door for further base rate cuts despite mixed messages from the Bank of England. One eye however must be kept on the upcoming Budget.
  • The Federal Reserve is being pulled in different directions by its dual mandate, but with recent hurricanes and the upcoming election it isn’t clear what it will do next.
  • The European Central Bank faces a clearer picture, with questions more around the size and length of cuts rather than the frequency.

Cooling inflation boosts the case for Base Rate cuts

Primary concern for the Bank of England (BoE) is of course inflation figures, but a keen eye is on GDP and earnings to help gauge whether service-sector inflation is likely to remain hot. On October 11 we had the August GDP data, growing a reasonable 0.2% on a monthly basis, up from the 0.0% flatline in July but not exactly hinting at overheating. This was followed by the average weekly earnings figures on October 15, perhaps of even more interest to the MPC, slowing to 3.8% in August from 4.1% a month prior and hinting towards what was to come with the September CPI release the next day. 

That September CPI print ultimately came out at 1.7% (down from 2.2% in August), not only considerably undershooting the Bank of England’s target of 2.0% but also beating surveyed economists’ aggregated prediction of 1.9%. The key driver was the all-important service sector inflation falling to 4.9%, particularly helped by dropping air-fares, taking much of the heat out of the headline figure.

The immediate reaction was for traders to fully shore up bets on the Bank of England cutting base rate at the November 7 meeting, with a total of 44 basis points (bps) of cuts priced in across that and the December meetings. Swap rates all shifted down with shorter-term rates more impacted (see chart), further flattening the yield curve and helping to push the spread between 2-year and 10-year gilts further above zero. This continues the downwards trend in swap rates seen throughout October but at a much greater pace and now approaching levels not seen since the end of September.

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Despite the data there seems to still be division within the Monetary Policy Committee (MPC) over how quickly to loosen rates. On October 3 Andrew Bailey, governor of the BoE, suggested that it could be “a bit more aggressive” in cutting interest rates provided the news on inflation continued to be good. It was only the very next day that Huw Pill, chief economist of the BoE, argued that are reasons to remain cautious given the possibility of structural changes sustaining more lasting inflationary pressures. Expectations of rate cuts were trimmed, but the uncertainty is more reflected in the MPC’s meeting in December rather than November. 

Of course the Budget on October 30 will play a big part in the rate-cut path, and the Chancellor will be careful not to repeat the lesson of 2022’s mini-budget which saw gilt yields and swap rates soaring as “bond vigilantes” revolted against un-costed spending promises. 10-year gilt yields had at one point climbed 21bps since the start of October but 10-year US Treasury yields climbed further narrowing the spread (see chart). The fact that sterling has lost some ground against the dollar but is still sitting higher than 1.30 and above its pre-August range indicates this is more due to changing interest rate expectations rather than fiscal doubt, as Daniel discussed above. A sensibly costed budget should see gilt prices rally and yields fall, bringing swap rates down with them and perhaps allowing Andrew Bailey to be “a bit more aggressive” indeed.

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Still a foggy path for the Federal Reserve

The interest rate outlook for the US remains murky, but is becoming clearer. Data releases lately are painting a picture of an economy that remains resilient, despite some concerns for the labour market, and that having started the rate cutting cycle with a 50bps cut the Federal Reserve is likely to revert to more conventional 25bps moves. 

Market forecasts for interest rate cuts were dialled back heavily after the Friday 4 jobs report showed surprisingly strong growth for September and fuelled fears of a “no landing” scenario. The main focus however was on the September CPI data released on Thursday 10, showing 2.4% annualised growth, hotter than the 2.3% expected but still down from August’s 2.5% reading. Despite inflation falling slower than expected markets actually increased their forecast path of rate cuts to 43.4bp by end of 2024 thanks to a sharp rise in unemployment claims revealed at the same time as the inflation data, reflecting the Fed’s competing priorities with their dual mandate. Of course the impact of the hurricanes landing in Florida is still be assessed, but it has been suggested it could reduce October payroll figures by as much as 100k jobs, adding further pressure for interest rate cuts in the short-term.

None of this is to speak of the political risk to interest rates. With the US election on November 5 currently too close to call, whichever of President Trump or Vice-President Harris takes the Oval Office the markets will react accordingly. The economic community is generally more critical of Mr Trump’s policies amidst fears that sharp trade tariff increases coupled with migration cuts could be stagflationary (reduce growth whilst raising inflation), and so a Trump rather than Harris victory on November 5 is more likely to see rising swap rates and bond yields.

Lagarde lays it out; more cuts to come

The outlook for the Eurozone appears to be a clearer picture, with several members of the ECB telegraphing a third 25bps cut in the week running up to their October meeting after softer economic data indicated that inflation could remain close to their target of 2%. October 17 brought both the finalised September CPI data (1.7% year-on-year, down from 2.2% in August), and the latest rate decision. 

The decision was very much as expected, with a unanimous 25bps of cuts to all three key reference rates (Deposit Facility, Main Refinancing, and Marginal Lending Facility), with the former being the one most focused on and now sitting at 3.25%. Following the announcement President Christine Lagarde gave comments to the press, striking a somewhat dovish tone in stating that although inflation is expected to rise in the coming months, economic activity has been “somewhat weaker than expected” with risks tilted to the downside. The ECB faces two-sided risks to inflation, with strong wage data and rising geopolitical tensions posing the possibility of rising inflation in countenance to subdued economic growth and lower demand for exports. All considered, some policymakers are clearly concerned about undershooting their 2.0% inflation target in the medium-term, with the September accounts stating “that the risk of the target being undershot further out in the projection horizon was becoming more significant”.

Consequently a further 25bps hike at the next meeting in December looks very much on the cards, with markets pricing in 37.2bps of cuts in the aftermath of the October meeting, but questions still remain as to where rates will eventually settle. At time of writing traders are betting that 25bps cuts will persist until April, taking the Deposit Facility rate to 2.25% or even lower with some outside bets placed on a 50bps move in December. It seems for the ECB the question isn’t so much will it continue with successive cuts, but a case of by how much.

Thomas Barker, Capital Markets

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