Swap rates lower in spooky season, can it last?

September’s UK inflation print brought a rare bit of good fiscal news for Chancellor Rachel Reeves. The expectation was that headline inflation would rise to 4% but in the event it stayed flat at 3.8%. In the run up to the budget, this helps the chancellor in two key ways: first, gilt yields dropped on the news and have now fallen during a time period that the OBR is likely to use in its forecasting assumptions. Second, the government’s welfare bill will rise by less than expected, given September’s CPI figure is used to index benefits. While this helps somewhat reduce the government’s fiscal black hole, November’s budget still presents major challenges for Rachel Reeves to meet her fiscal targets – something I will come back to later on. 

The undershoot in CPI is also, of course, a welcome bit of news in the UK’s fight to get back to 2% inflation in the medium term. However, UK inflation remains nearly twice the Bank of England’s target and continues to be an outlier when judged against comparators in the developed world (see Figure 1). This discrepancy is largely accounted for by significant increases in UK regulated prices that came into force in April this year, but inflation expectations in the UK are leading to worries about the potential for inflation persistence.

How worried should we be about inflation expectations? It depends who you ask. Consumers seem to be concerned: their expectations for inflation in the medium to long term are elevated at the moment, no doubt due to high food price inflation that is very visible to households on a day-to-day basis. Financial markets, on the other hand, disagree with households on this point: their current expectations for inflation in 5-10 years’ time are lower than the pre-pandemic period (see Figure 2). Who’s right remains an open question and it is a topic to which we will return to in future Rate Wraps. 

Back to the upcoming November budget. Despite the good news coming from September’s inflation print, it would still seem reasonable to assume that Rachel Reeves will need to raise £25 – 30bn and that most of this will likely come from taxation. The fiscal gap will mostly be driven by a combination of downgrades to expected productivity growth as well as government U-turns on welfare reform. Moreover, in an attempt to sooth financial markets, the chancellor is also expected to try and leave a higher level of headroom for her fiscal targets compared to last year. Freezing of income tax thresholds as well as the introduction of some environmental and “sin taxes” seem almost certain to happen, but this will still leave a major funding gap and it remains to be seen what other measures will come forward. The sums of money involved mean Rachel Reeves may even have to breach the government’s manifesto commitment not to change income tax rates. 

In terms of what this all means for forecasted rates, we continue to believe the evidence points to a cautious continuation of the rate cutting cycle. Our call at the moment is for there to be a further three rate cuts over an extended period of roughly 18 months as rate-setters continue to balance inflation persistence worries with signs of labour market weakening. There are, of course, a variety of upside and downside risks to this forecast for base rate pathway outlined in the table below, but I would say that these risks are now finely balanced.

October in isolation has seen a chunky drop in UK swap rates across the curve, touching new lows of 2025. As has been asked during other brief periods of swap rate reductions this year, like in April, June and early September, will these new levels hold?

Firstly, we need to look at the reasons for the reductions in market rates across tenors. Data of course is the obvious driver, but other tailwinds are also evident, discussed below.

“Soft” surprises in UK data

The obvious driver of the drop in rates this month has been lower than expected private sector wage growth in August, and more importantly a miss in headline inflation figures for September. The labour market data across August and September which was released this month contained snippets to please both the hawks and doves. PAYE payroll data appears to be stabilising rather than falling, and job losses over the last year have been revised quite substantially lower – whilst hardly a sign of a booming labour market, it equally does suggest an aggressive cyclical downturn. The doves will point to a higher unemployment rate, albeit this looks to be erratic, and lower than expected private wage growth – falling to 4.4% on a three month/YoY basis, under the Bank of England forecasts.

Inflation undershooting expectations triggered a 10bp fall in swap rates. The expectation was for headline inflation to increase to 4%, double the target, but instead remained unchanged at 3.8% - with surprises seen in many components – notably food prices which fell on the month. Markets have seemed to latch onto the drop in food prices, on the view that it may ease concerns on Threadneedle Street about unanchored inflation expectations. Swap rates have fallen c30bps from the October highs – The 5-year swap trades just above 3.5%, and markets now price in a strong chance of a 0.25% cut this December.

US Drama

As is typical in 2025, headlines in the US, or in some cases the lack thereof, have also helped drive UK swap rates lower . The ongoing government shutdown and the subsequent delays to key data releases have left the market leaning dovish on US rates, given the last available employment data released in September was extremely poor. A lack of data otherwise keeps the status quo, or the outlook paused in time, in favour of further interest rate cuts from the Federal Reserve. This is backed up by recent comments from Fed Chair Jay Powell, admitting that downside risks to employment have risen, whilst also hinting that an end to quantitative tightening is in view.

News of bankruptcies of regional banks in the US caused another market wobble, reminiscent of the collapse of SVB bank in 2023. Whilst the incidents seem isolated and risk of contagion seems small, incidents of loan fraud and a lack of sufficient controls/governance does spread concern around the true quality of US credit, where spreads have tightened considerably this year. The news spurred a rally in US Treasuries, with the 10-year yield now trading below 4%. Perhaps some restoration of its safe haven status, but the jury remains out given US finances remain on an unsustainable trend.

Is there a majority within the MPC willing to back a rate cut?

We have detailed before in the Rate Wrap that there is a group of Monetary Policy Committee members who want to cut rates (even if they have voted to keep rates unchanged on different occasions) when conditions allow – including BoE Governor Andrew Bailey himself. 

Recent commentary suggests some dovish tilts too, making an argument for a rate cut this year potentially more convincing. Dave Ramsden and Sarah Breeden are notable members who have expressed economic concerns in September speeches. Sarah Breeden warned about the risks of holding interest high for too long as a speech in Cardiff, whilst Dave Ramsden stated at a speech in Frankfurt that he sees scope for further removal of policy restraint. Both members are seen to be in the neutral territory of the BoE, add in the two doves (Swati Dhingra and Alan Taylor) plus Mr Bailey himself, there is a scope for a narrow 5-4 majority in favour of another cut – albeit likely in December rather than November.

Budget speculation

In recent years, speculation ahead of a UK budget normally rallies concerns around what the potential spike in UK gilt yields will be, and whilst that still is a concern this time around, two-way risk on gilt moves cannot be underestimated. Notably, gilt yields have also fallen considerably this month, outperforming peers, linked to the above-mentioned factors. But the fall was also helped by news of a £2bn revision higher of VAT receipts in this fiscal year, therefore also revising lower borrowing numbers marginally. This provides Chancellor Reeves with miniscule relief, but not enough to avoid the sleepless nights. Estimates of the hole Ms Reeves needs to fill range between £25bn to £40bn+, funded through tax rises and/or spending cuts, both reducing economic output and reducing inflation over the longer term.

Sources suggest this budget could be a “big one”, hinting that measures will be front-loaded, or headroom will be increased (perhaps doubled?) from the current £10bn to reduce the likelihood of further changes at future budgets. This opens up the possibility of lower yields post-budget, on both calmer markets and reduced growth potential – possibly dragging down swap rates further.

Can these levels persist?

In theory, yes, but there is a risk markets have become slightly trigger happy this month. Monthly data is erratic, and to rely on  month’s dataset is always a risk. Indeed, the unemployment rate increase looks like it could rebound lower. Whilst the inflation data was welcome, inflation remains double the 2% target, but UK consumer confidence is picking up and retail sales rising – supporting a view that the job market is loosening only gradually. Indeed, downward pressure arising from the US could reverse if we get positive data surprises once the shutdown eventually ends, and the inflationary impulse from tariffs may start to bite the US soon, constraining the Fed. 

In conclusion, the argument for a sustained decrease in swap rates remains unconvincing as of right now, as has been the case in previous downturns this year. Investors are taking advantage of what has been perceived by some as a window of opportunity, locking in rates at the most attractive levels since September 2024 – perhaps as part of a long-term or blended risk management strategy.

Cameron Willard, Capital Markets