No summer break as markets remain focused on fiscal policy

July saw a spotlight on the fiscal sustainability of government debt. We project that term premia associated with UK gilts are likely to be sustained, or could even grow, as this decade progresses. And while a base rate cut seems likely in August, expect only a modest and cautious continuation of the cutting cycle following this point.  

This month’s Rate Wrap will focus on two themes: first, an examination of how financial markets are pricing risk associated with sovereign debt markets; second, the latest short-term outlook for base rate pathway in the UK. 

Concerns relating to fiscal sustainability of UK government debt came to the fore in early July when speculation gathered that Rachel Reeves’ position as Chancellor of the Exchequer could be at risk. This speculation was, of course, triggered by a perception at Prime Minister’s Questions that Keir Starmer may not have been fully behind his chancellor. Markets took fright at this prospect due to the interpretation that this may mean the UK’s fiscal rules could be on the chopping block: it is notable that the 30-year gilt yield jumped by 20 basis points at one point on 2 July. 

The gilt market did eventually settle when Keir Starmer gave overt backing to his chancellor, although the long end remains under significant pressure. And, while the certainty associated with Ms Reeves staying in place has certainly been welcomed, it is important to stress that financial markets have been increasingly expressing concerns about fiscal sustainability of government debt in the UK and across the western world for some time now. Since 2023, for example, there has been growing “term premia” for sovereign debt markets – in essence, an increasing premium associated with the risks of lending long versus short. The term premium is not directly observable, but a decent proxy for this is comparing 30-year government bond yields to 10-year government bond yields. As you can see from Figure 1, this proxy for term premia has been on an upward trajectory right across G7 economies over the past two and a half years. 

In our recent Macro Comment Are financial markets fully pricing in fiscal sustainability? Opens in a new window, we make a call that the current term premia on UK gilts will be sustained, or could even increase, as the decade progresses. This is because the new political context in the UK – exemplified by the recent climbdown on welfare reform and the government’s poor opinion poll ratings – will make it difficult for policymakers to implement measures that alter the long-term trajectory of sovereign debt onto a more sustainable basis. The next pinch-point with respect to this will be the autumn budget, where it is estimated that Chancellor Reeves will need to find between £15–25bn to continue meeting her fiscal targets. 

Turning to shorter-term macroeconomic matters, the next Monetary Policy Committee decision on base rate will take place on 7 August. Continuing signs of a loosening labour market certainly point in a dovish direction for this meeting: for example, the unemployment rate ticked up to 4.7% in May and the number of people in payrolled employment fell by 41,000 in June. Payrolled employment has been on a downward trajectory since October 2024, coinciding with the announcement of increases to employers’ National Insurance Contributions. However, despite this, inflation persistence continues in the background of the UK economy: the latest print for headline inflation registered 0.2pp above expectations at 3.6%; services inflation remains elevated at 4.7%; and, as highlighted in the previous Rate Wrap, y-o-y CPI is expected to be north of 3% until at least April 2026, which ostensibly sets the scene for a difficult environment to cut rates.  

The clear signs of further loosening in the labour market and cooling pay growth lead financial markets, as of 22.07, to price a roughly 90% chance that a majority of MPC members will end up backing a rate cut in August. We would agree that an August rate cut remains a likely outcome, especially since base rate will still be in restrictive territory even if it dropped from 4.25% to 4%. However, from August onwards we continue to expect only a modest and cautious continuation of the rate cutting cycle given that inflation persistence remains a serious concern for policymakers. 

Daniel Mahoney, UK Economist

Swap rates stuck between a rock and a hard place

Whilst July had no monetary policy decision from the Bank of England, there was still plenty to digest. As daily watchers of the UK swap market, it’s very clear that there is currently a lack of direction. Hard economic data and a deteriorating outlook act as an anchor that has tried to pull swap rates lower in recent months – we have seen notable dips throughout April on the initial uncertainty surrounding tariffs (and its potential economic impact), and again last month following the downside surprises in payroll numbers and GDP for April. But there is not enough in the data at the moment to drive a more sustained move lower in the swap rates, likely down to a couple of reasons.

Firstly, the outlook for inflation, and how much of this is “sticky” remains a key topic of conversation, the hard data shows headline inflation remaining above target, and forecasts suggest it will end the year comfortably above 3%. The “hawks” within the MPC are worried that the transmission effect of unanchored inflation expectations leads to stickier inflation down the line, and therefore will be much harder to bring back down to the 2% target.

Secondly, the pressure on sovereign bond yields globally is playing a part – at least in the short-term. This is not just impacting the UK in isolation, concerns around fiscal sustainability have been well documented in the US – notably in the context of the recently-approved “One Big Beautiful Bill” (OBBB) which according to the Congressional Budget Office would increase US borrowing by $3.3tr over the next nine years. Similar concerns have arisen in the likes of Japan as many expect fiscal expansion to accelerate as approval ratings drop and the economic outlook sours. 

However, the UK does get a lot of the headlines as a consequence of the 2022 mini-budget debacle. This was evident on July 2  following Prime Minister’s Questions where Keir Starmer failed to back his chancellor Rachel Reeves when asked directly. This alone highlighted the market’s sensitivity to political/fiscal developments, with yields up across all tenors, as far as 20bps at its peak in the 10-year sector on July 2. 

In relation to the swap market, movements in bond yields can have a short-term impact. Noted, swaps and bonds are different assets with different risk profiles (a gilt carries the risk of non-repayment by the UK government) and therefore over longer timeframes fiscal sustainability concerns should be reflected by a higher risk premium embedded into sovereign bonds relative to swaps – in other words a higher spread between the two. But short-term swings can also correlate with similar movements in the swap market. Take July 2 as an example, where the 10-year gilt yield closed 10bps higher relative to its ‘pre PMQs’ level, the 5-year swap rate increased by 7bps.

The next big question is how much fiscal concern, economic concern, and other extremes such as central bank credibility are being priced in by the market. Fiscal sustainability concerns worldwide are not a new story, and from a UK perspective, the recent U-turn on welfare reform and the growing need for the government to act (via tax increases) in the autumn is a near certainty – therefore it should already be in the price. This makes the reaction to Chancellor Reeves’ potential early dismissal rather peculiar, as the same problem faces whoever is in post, whether it be Reeves or someone else.

However, compare this to the market reaction following a leak from inside Washington on July 16 that President Trump would look to fire Federal Reserve Chairman Jay Powell before his term ends – what many put down to his frustration at the lack of interest rate cuts coming through – which arguably puts the Fed’s independence into question. Yet, whilst there was a brief period of souring sentiment before the news was denied, we did not see a fallout (severe spike in bond yields) that one might expect to witness – so is the market perhaps already part-expecting such an outcome?

All in all, whilst political noise can increase volatility seen in the swap and bond market, what matters more is how the market sees the economic outlook, which comes from hard data, and how this alters the view of the Monetary Policy Committee – and right now this still supports gradual reductions in interest rates in the UK. Of course, the fiscal situation has knock-on effects for economic growth and interest rates, and with taxes likely to be going up in the autumn budget, textbooks would suggest this should worsen the economic outlook and act as a downward force on interest rates – all else is being equal. 

Cameron Willard, Capital Markets