Rates remain stubborn heading into 2025

UK growth risks to the downside and inflation risk to the upside as we go into 2025

The UK goes into 2025 with a relatively difficult macroeconomic backdrop, which we set out in detail in the latest Macro Comment State of the UK economy: Mixed outlook for 2025. 

In summary:

• The UK’s fiscal targets appear to be at risk. Even at the time of the Budget, the Office for Budget Responsibility (OBR) predicted that Chancellor Rachel Reeves only had a 54% chance of meeting them. And since then, developments suggest this likelihood has decreased, with borrowing costs now well above those assumed by the OBR, business sentiment souring following the Budget and the prospect of increased global tariffs. 
• The Bank of England’s (BoE’s) less sanguine scenarios for inflation – namely that some degree of slack in the economy is required to get inflation down to 2% in the medium term or that structural changes in the UK economy mean inflation will persist for longer and require fewer interest rate cuts – currently appear to be the most likely to play out. Wages and services inflation continue to run hot while the UK’s fiscal policy and potential inflationary spillovers from the US are likely to add inflationary impulses. 

Our relative economic position compares quite favourably to other major European economies, not least due to the relative political stability in the UK, but we judge that UK growth risks are to the downside and inflation risks are to the upside. This is a tricky context for the BoE to be operating in. Worries concerning inflation persistence meant the Monetary Policy Committee held rates in December and, while we should still see the rate cutting cycle continue to proceed in 2025, it will in all likelihood occur at a very cautious pace. 

Our full economic and financial forecasts will be published in the next Global Macro Forecast on January 22 2025. Until then, wishing all Rate Wrap readers a Merry Christmas and Happy New Year.

Daniel Mahoney, UK Economist

Lack of Christmas cheer in the rates market

Year-end can always be a tricky one to tackle, with traders and investors continuing to deal with incoming data, whilst also digesting central bank decisions (Fed and Bank of England amongst others). On top of this, there is also dwindling liquidity as the holidays approach, and the financial year ends and some institutions start to “window dress” their balance sheets. A mixture of all the above can at times create a complicated, choppy trade environment.

December has seen a reinvigoration of higher interest rates, evidenced in the short end as traders price out interest rate cuts over the next year. Further out along the curve we are seeing the higher for longer theme cement itself with long-end bond yields pushing higher along with swap rates. Zooming in on the US 10-year Treasury yield as an example, the yield has increased from a low of around 4.15% to 4.5% post Fed meeting (see below). The move higher has been attributed to many reasons: US growth prospects and higher interest rates, growing risk premium in relation to the impending Trump administration, or just year-end effects. A mixture of all seems about right, and the direction of travel seems to be only heading higher. Across various forecasters many see a near-term target for the 10-year yield above 5%, whilst some even extend further, seeing a risk of 6%. 

The Fed’s December decision as expected resulted in a 0.25% cut (albeit it was closer than most thought), but markets were taken aback by the hawkishness of the supporting statement and forecasts. The Fed lifted its 2025 inflation forecasts from 2.2% to 2.5%, whilst also forecasting cuts of only 50bp in 2025, from 100bp back in September. Despite markets already sharing this opinion prior to the Fed meeting, it seems many were surprised by the inflation forecasts as well as the fact that one of the voting members, Beth Hammack, dissented and opted for a hold this month. Chairman Jay Powell also mentioned that concerns around the labour market have cooled for now. Markets reacted by shifting rates higher across the curve,  but notably seeing increasing risk that rates do not go below 4% next year (c30bps of cuts now priced in only, first move in July). Markets can be emotional, and thinned liquidity may also be exacerbating the reaction to the decision, but underlying hawkishness is clear to see – central bank divergence among the Fed, European Central Bank and Bank of England, now looks to be a headline story for 2025.

As for the UK, there is perhaps greater justification for the move higher in rates throughout the month. No doubt that the US moves have played a part, but lofty wage growth numbers for October and sticky underlying services inflation have also contributed to the domestic move. The inflation numbers for November were expected, but markets were caught off guard by the annual increase in wage growth (both including and excluding bonuses) which printed at 5.2% - blowing all expectations out of the water. As a result markets have moved to effectively price out one 25bp cut for 2025, which now only shows 0.5% worth of cuts priced in for the year. As for the swap curve, we are now above 4% again all the way out to 10 years – the 5-year is up 30bps on the month alone. A staggering move, and now not far from the highs seen post-US election.

The Bank of England meeting provided some dovish surprises with three members voting for a cut (6-3 decision in favour of holding rates at 4.75%). It is clear that there is a divide within the committee over whether emphasis should be placed on inflationary or growth concerns. Whilst inflationary concerns for now suggest that a gradual approach to rate cuts is the most prudent route, this decision highlights that if conditions allow, the MPC may well be ready to press the accelerator on rate reductions.

It doesn’t seem like we will get much domestically to help push swap rates lower in the early part of 2025, inflation will continue pushing higher on government measures and base effects, whilst there are no clear signs the stickiness in services inflation with dissipate quickly. Despite some signals from the PMI data that employment may be taking a turn lower, this seems to be driven more by the manufacturing sector rather than the services sector. Even if rates remain stubbornly higher, the domestic and global uncertainties still provide evidence that hedging strategies play a key role for businesses, given it’s one area of a company’s cost base that can be controlled and is predictable.

European drama

Despite the above, generally we have seen market focus drift away from the US a little in December and onto Europe given renewed political woes in both Paris and Berlin. Despite lingering uncertainty with a looming election in February and continued economic pain, German bunds have moved sideways during December thanks to their role as the European benchmark and a typical safe haven. Domestic risk in France has been much more apparent following the collapse of the government led by Michel Barnier, a government that lasted only three months.

The government was toppled as all parties failed to agree on a Budget for 2025, with the left-leaning coalition and Marine Le Pen’s far right National Rally party (both extremely opposed to Barnier’s Budget proposal) joining in unison in a no-confidence vote which was triggered after the government tried to use constitutional law to pass the Budget bill. As a result France is effectively back to where it was in July. New elections cannot be held until 2025, and much-needed measures to address the budget deficit are further delayed. Unsurprisingly we have seen pressure on French government bonds (OATs), with the spread between 10-year German bunds and OATs reaching the summer highs of 0.88%. The 10-year yield briefly exceeded that of Greece (historically seen as the riskiest in Europe) whilst still trading at similar levels now. For context just 12.5 years ago during the eurozone debt crisis, the 10-year Greek note yielded 37% more than the French equivalent. Any further increases in French yields may be capped in the near term given a lot of pessimism may already be in the price, but will be a keen watch for both the markets and the ECB in the coming months.

Talking of the ECB, after a lot of chatter about a potential 50bps cut from the ECB this month, markets eventually gravitated towards a smaller move. Indeed, a 0.25% cut was the final verdict as the ECB bought the deposit rate to 3%. Within the statement, the omittance of the need for “restrictive” rates was duly noted by markets, signalling more rate cuts are to come as concerns around the eurozone growth outlook intensify. Markets see another 1.25% of cuts over the next year, taking the deposit rate to 1.75%.

Wishing you and your family a very Merry Christmas from the Rate Wrap team.

Cameron Willard, Capital Markets