The calm and the storm

From a macro perspective, the budget was a fairly inconsequential event, delivering only modest fiscal changes. While headroom against the government's fiscal rules narrowed and fiscal policy was tweaked at the margin, the overall package was close to expectations and led to virtually no market reaction. This was all broadly expected and Chancellor Healey will be pleased that he’s continued a run since late July of UK domestic politics not leading to any major moves in gilt yields. Indeed, as highlighted in the previous Rate Wrap, the spread between gilts and many Euro government bond markets has narrowed since the summer, a trend that we previously predicted Opens in a new window.  

However, longer-term difficult issues have been punted to the Spending Review, which could potentially take place as late as autumn next year. Current plans do not address how the UK will deliver an additional £11bn by 2030 to hit a target of spending 3% of GDP on defence, and existing plans for fiscal consolidation imply real-term cuts to some government departments. Healey will hope that geopolitical risk recedes and the economic outlook, in turn, improves by the time of the Spending Review, but this is clearly far from guaranteed. 

The budget is small in fiscal terms and, as a result, will not materially affect interest rate expectations. Recent UK macro developments are pointing in a firmly hawkish direction. Even with the government’s announcements to ease cost of living pressures, inflation is now on track to be well north of 4% by the beginning of next year right at the time when many people have their pay reviews. 

Moreover, latest jobs data suggests that the UK’s employment picture is beginning to stabilise, so the Bank of England (BoE) cannot rely too much on the labour market being weak enough to bear down on potential second-round effects arising from the energy price shock. And economic activity continues to show signs of resilience, with the composite Purchasing Managers Index (PMI) rising from 52.0 to 53.1 in October. 

As we projected in our latest Global Macro Forecast Opens in a new window (GMF), the BoE is now lined up to increase interest rates for the first time since the US-Iran war at its next meeting on November 5. In the GMF, we expected this to be the only hike of the cycle. Even that represented a significantly more hawkish outlook than prior to the US-Iran war, when we anticipated two rate cuts. However, the persistence of the energy price shock suggests the BoE will likely need to tighten further than we previously anticipated. We will update our forecast in due course to account for this. However, financial market pricing for four to five rate hikes over the next year still appears excessive.

Daniel Mahoney, Senior Economist, UK

October has been another month dominated by fiscal policy, inflation concerns and global bond markets moves. While the UK market has taken comfort from a relatively uneventful budget, a backdrop of rising energy prices and resilient economic data sees investors continue to reassess the outlook for interest rates on both sides of the Atlantic.

A “boring budget” to keep the bond market happy

I won’t go into too much detail around the budget, as Daniel has already outlined in his section above some of the key takeaways. The modest announcements have kept the bond market on-side, particularly amongst a wider backdrop of bond market turmoil in Europe - which I will talk about more later. 

The Office for Budget Responsibility (OBR) downgraded the chancellor’s fiscal headroom from £23.6bn in March to £15bn, primarily driven by higher gilt yields over the course of the year adding to debt-interest costs. The longer-end maturities for UK gilts outperformed as the budget had no major surprises, and planned issuances from the Debt Management Office (DMO) for long-end gilts has reduced. Bloomberg research shows that many analysts had estimated roughly a 20 basis point premium baked into the 10-year yield ahead of the budget, which fell a modest 3bps on Budget Day, and the 30-year falling 5bps. 

Broadly across October the gilt curve has flattened, with the long-end falling and the short-end rising on BoE tightening expectations. The budget has then reinforced this trend, with Chancellor Healey’s undertones of fiscal discipline appeasing the longer-dated gilts. The UK 2s10s spread has narrowed over 20bps since the start of the month, but the front end is struggling to break the 5% level, despite Brent crude continuing to push higher to around $115 a barrel, as market pricing has already factored in an inflation shock and 100bps of tightening from the Bank of England by the end of summer next year. 

There’s an argument to be made that market pricing is more pessimistic than the general consensus of economist forecasts and how realistic 100bps of tightening is, but market pricing remains anchored at current levels for the time being with UK data surprising on the upside this month, inflation expected to top 4% early 2027 and the Bank of England’s Monetary Policy Committee being the most hawkish it has been since 2023. SONIA overnight swap pricing has almost fully priced a November hike (97% chance priced), with 56bp of tightening priced by February next year. 

French bonds face a cocktail of fiscal uncertainty and political risk 

French government bonds (OATs) faced one of their most volatile months in recent years. The OAT-Bund spread is the risk premium that investors demand for holding French bonds over German bonds, and the spread widened at its peak to around 175bps, its highest spread since 2011. This is due to a toxic combination of fiscal concerns and political risk within France, with the start of October seeing the French budget unveiled, presenting a deficit reduction from 5.4% to 5.0% of GDP in 2027. This was met with both punishment from the bond market, pushing yields higher, and France’s fiscal watchdog HCFP warning that the economic assumptions that were the foundation of the plan were “optimistic”. The ECB ruled out intervention despite soaring bond yields, with French Finance Minister Lescure stating that France was “far from needing ECB help”, and ECB member Moulin saying that the French bond market is “complicated and serious”, but that the conditions for intervention from the ECB were not met. 

As widely publicised, mid-October saw the breakout of protests that spiralled into widespread violence, looting and riots. The French government responded by banning demonstrations in Marseille and implementing curfews, which is when we saw the OAT-Bund 10Y spread peak. We saw the spread fall 13bps to 154bp on 26 October when Moody’s kept France’s credit rating unchanged at Aa3 Negative, amid fears the rating may have been downgraded given the unsustainable path of France’s finances. 

OATs are likely to remain under pressure as we approach the presidential election in France next April/May, and sovereign risk is described as one of the highest in the EU. France has had four prime ministers in the past 24 months, and the polling currently is between Marine Le Pen on the far right and Jean-Luc Mélenchon on the far left. With both the budget vote scheduled for 17-18 November and the 2027 presidential election on the periphery, OATs are likely to remain under pressure and continue to trade near a 15-year high. 

The ECB will structurally see a shift in 2027 as President Christine Lagarde has announced her departure in February, earlier than expected. Front-runners are considered to be Spanish central bank Governor Pablo Hernandez de Cos and former Dutch central bank chief Klaas Knot.

Federal Reserve keeps rates on hold, for now

The Federal Open Markets Committee voted 10-2 to hold the target range at 3.75%-4% after delivering a 25bp hike in its September meeting. Fed Chair Kevin Warsh highlighted the FOMC remains ready to act if needed, and that it’s shown its “willingness to act” already. There is currently an 84% chance of a December hike priced in, and structurally Warsh announced that the FOMC will reduce the number of rate decisions per year from eight to six, starting in 2027. It will continue to hold eight meetings, but one will be used for “broad monetary policy strategy” without a rate vote or statement, and a second non-rate meeting added in 2028. Market reaction saw the 2-year US Treasury yield fall 7bps, compared to the 30-year yield rising 6bps, as markets price out near-term hikes following Warsh’s dovish tilt.

On the political front in the US, midterms on November 3 are looking likely to deliver a divided Congress, with the Democrats favoured to retake the House, but the Senate remaining uncertain. Key Senate swing states are Texas, Kansas, Ohio, Iowa, Maine and North Carolina, with the Democrats needing a net gain of only four seats to flip the chamber. President Trump’s approval rating is at an all-time low currently, with voter sentiment focused on high fuel prices and affordability concerns. The results of the midterms will be key for not only policy, but also ahead of the US government’s debt ceiling which is due to be reached in mid to late 2027.

To summarise, October has shown that while central banks take centre stage for market pricing, fiscal policy and politics are powerful forces too. The UK's relatively uneventful budget was enough to reassure gilt investors, while France experienced first-hand how concerns around public finances and political stability can feed into sovereign risk premiums. 

As we move towards year-end, markets appear comfortable with current rate expectations (contrary to economist expectations), but with energy prices elevated and geopolitical risks still present, there is little sign that volatility will disappear altogether.

Jasmine Crabb, Handelsbanken Markets