Tug-of-war continues for the Bank of England

Since the last Rate Wrap, some red lights on the economic dashboard are flashing that little bit more brightly. Geopolitical risk remains on the agenda with oil prices staying at elevated levels. Moreover, UK gilts have continued to face strain with the 10-year yield above 5% again (as of 25.08) as August saw developed sovereign bond markets under pressure across the board. This is primarily the result of fiscal concerns relating to the sustainability of government finances as well as increased competition for investor capital in the context of the AI boom.

Despite these concerns, UK domestic data continues to show that compared to previous expectations the economy has been far more resilient to the consequences of the US-Iran war. Q1 and Q2’s growth of 0.6% and 0.4% respectively was notably better than expected, and likely points to households reducing their savings rates to deal with cost of living challenges. Annual inflation jumped from 2.6% to 2.9% in July, accounted for by the increase in the household energy price cap, but across the year CPI prints have notably undershot expectations. While the energy price shock has lifted headline inflation, and will continue to do so with a further rise in the household energy price cap in October and possibly in January next year as well, disinflation in services inflation and wage growth seem to have helped somewhat offset the impact so far.

Business and consumer confidence surveys are telling a reasonably good story, too. August’s provisional PMI registered at 52.5, indicating reasonable private sector expansion, while consumer confidence rose by three points due to improved sentiment from a change of resident in 10 Downing Street. This rosy picture looks set to be short-lived, however. Inflation is now expected to be north of 3% for the remainder of the calendar year, geopolitical volatility remains ever-present, and concerns about a fresh round of tax rises in the Budget on 28 October will no doubt dampen confidence. Growth is set to be suppressed in the second half of the year. 

Turning to the latest Bank of England decision on base rate, the MPC’s “wait and see approach” continues with rates held at 3.75%. Six members backed a hold in rates and three advocated for a hike. The doves are reassured by evidence of continued disinflation and also point to the tightening of financial conditions (ie higher government bond yields) as being a useful “insurance” against upside inflation risks. The hawks are less convinced about the disinflation process (many pay surveys suggest earnings are hotter than the official ONS data, for example), and argue that a proactive rate hike is needed to tackle upcoming second-round effects from the energy price shock. For example, some of these effects are expected to materialise at the end of this year and beginning of next year when many people have their pay reviews.  

Clare Lombardelli, an MPC member currently in the “hold rates” camp, is thought to be the closest to switching her vote to a hike. Ms Lombardelli was clear at the press conference after the July decision that her vote to keep rates at 3.75% was “not a close call”. However, given oil market futures remain high it would seem likely that concerns around second-round effects could very plausibly spread beyond the current hawks, and there is a strong possibility that at least two further MPC members will end up backing a base rate increase at some point this year.  

Meanwhile, look out for our next set of financial and economic forecasts for the UK and elsewhere which will be published in the next Global Macro Forecast on 9 September.  

Daniel Mahoney, Senior Economist, UK

Two opposing forces are competing in the Bank of England’s decision-making. Weak growth figures and a softer labour market need to be balanced against raised energy prices and what that means for inflation and second round effects, plus global bond market term premia and fiscal concerns. The ongoing tug-of-war is a difficult balancing act for the Bank of England, with swap rates higher across August. Market pricing still sees two rate hikes priced in by summer time next year.

The economic data is a tough sell

Looking firstly at the economic data (which Daniel explores above,) underlying the trajectory of a slowdown in growth, the devil is in the detail. The Purchasing Manager’s Index is a monthly health check on whether a sector is growing or expanding, and for August it posted a surprise reading on the upside. As Daniel explained, this suggests ongoing resilience within the UK economy despite the rise in energy prices, but still points to the direction of growth slowing, compared to H1 of 2026. An interesting take on how that slowdown may materialise is a research piece by Bloomberg on the impact of the hot summer, which uses ONS estimates for the percentage of productivity lost at different temperature bands. Given we have not been short of hot weather throughout August, in a nutshell, the expectation is that the summer heatwave could inflict another negative supply shock to the UK economy. 

The UK’s labour market isn’t looking as hot as its weather though. The latest figures from June and July point to continued deterioration, and the average weekly earnings seem to have settled within an acceptable range for the Bank of England’s 2% inflation target. If you’re looking purely at the economic data, a slowdown in growth, coupled with a soft labour market would point to the Bank of England keeping interest rates on hold for the rest of 2026. However, one of the key risks that market pricing is factoring in is demand staying firm, alongside elevated energy prices, which ultimately could feed into second round effects to inflation (which I will explore more below). This could in turn lead to an “insurance hike” from the central bank before year-end. SONIA overnight swaps pricing shows around a 15% chance of a hike priced into September’s meeting, with just shy of a 70% chance by November, and one fully priced in by year-end (as at 24/08). Beyond year-end, a further 36 basis points of tightening is priced into H1 2027 – suggesting that markets are torn between whether two or three hikes are needed between now and next summer. 

“Liquid gold” still plays a big role in market pricing

It’s no secret by now that developments (or setbacks) in the Middle East conflict and the subsequent impact on oil prices are feeding into interest rate expectations. The Strait of Hormuz handles roughly 20m barrels per day (pre-war) of global LNG flows, and 20-25% of global oil shipping. Current estimated volumes are around 5-7m barrels per day, according to Bloomberg. While there are alternative routes, the fundamental structure is insufficient to replace the scale through Hormuz fully, with around two-thirds of flows estimated to be unable to be diverted via pipelines if tankers cannot navigate the strait.

Through August, Brent crude climbed back towards the $100 level, touching $94 at its peak in mid-August. The lack of a ceasefire announcement, along with uncertainty around what US Treasury Secretary Scott Bessent’s “unprecedented measures” against Iran might look like, fed into this, and pulled up swap rates across the curve. 5 and 10 year swap rates increased by more than 2 year rates. This shows that inflation risks arising from higher oil prices are being priced into the longer-end of the yield curve, rather than the market's expectations for Bank Rate. We’ve seen a reversal from the peak following Scott Bessent’s “economic D-Day” speech where he announced a sanctions package and diplomatic pressure, but did not specify countries or deadlines. Some of the geopolitical risk premium has been removed from oil prices and swap rates alike on the assumption that these toughest measures may not materialise imminently. Overall, while a key driver for swap rates, oil prices aren’t the be-all and end-all. 

Taking the energy price movement into consideration, we saw July’s CPI reading rise to 2.9% (from 2.6% in June) as widely anticipated, with household energy bills the main driver of the upwards momentum. These rose 7% on the month after the reset of Ofgem’s price cap which now factors in the start of the US-Iran war, therefore households are now absorbing more of the wholesale energy cost increases, with Ofgem announcing on 26/08 a 4% increase to the energy price cap from 1 October. While the up-tick in inflation was largely priced in already, it has helped to keep swap rates anchored higher, particularly as the MPC voted on a hawkish hold in July’s meeting, as Daniel explored above.

Bond investors keep governments in check

The bond market has also played a part in the uptick in swap rates, particularly following the announcement of the US Treasury’s intervention in the bond market to increase buybacks of long-term bonds. This prompted a global sell-off in bonds, which fed through into swap pricing. Concern around the fiscal sustainability of G7 government debt and term premia has re-emerged, seeing the US 30-year yield breach 5.30%, and the UK 30-year yield hit 5.83%. The US Treasury yield reached the highest level since 2007, and other global sovereign bonds suffered a similar fate, including France and Germany, reflecting broader investor sentiment towards long-dated sovereign debt. These have since retreated following reports that Iran and Oman are discussing an “interim framework” for resuming shipping through the Strait of Hormuz, causing oil prices to fall and therefore easing some inflation expectations.

Forward-looking to the upcoming US mid-term elections, we should expect an even closer focus on a resolution in the Middle East as Donald Trump battles to regain voters’ confidence in his management of the economy.

Jasmine Crabb, Handelsbanken Markets