The bond market takes the wheel as rate cuts take more of a back-seat

In one respect, the September Monetary Policy Committee (MPC) meeting was pretty uninteresting. The key language relating to the future of UK base rates remains in place (a “gradual and careful approach to further withdrawal of monetary policy restraint remains appropriate”); the vote to hold rates at 4% by a seven-to-two vote was broadly expected by markets, and inflation risks continue to be on the upside. In essence, the MPC’s positioning was roughly the same as it was in August, which is set out in more detail in last month’s Rate Wrap. 

However, all eyes were, of course, on the decision made in relation to quantitative tightening (QT), something that began back in 2022. To date, this process of shifting government bonds from the BoE’s balance sheet back to the private sector has been running at a pace of £100bn per year, and this is something that has previously been unanimously agreed by all members of the MPC. Not this time, however. Every September, the MPC has to vote on the level of QT over the following 12-month period and, on this occasion, a majority of members voted to slow the pace of QT to £70bn, with just one member arguing that it would be appropriate to keep the QT pace at £100bn per year (see Table 1). 

The BoE has stated three clear principles with respect to its QT programme: first, that base rate is the primary tool of monetary policy; second, that the process should be smooth and predictable and, third, that financial market functioning is maintained. In light of its most recent vote, the MPC is indicating that at least one of these principles would not be maintained without reducing the pace of QT. 

Prior to the meeting, MPC member Catherine Mann had expressed her concern about monetary policy pushing in different directions on the gilt yield curve. In summary, while base rate falls have been pushing down yields at the short (ie, 2 or 5-year gilts) end, the QT programme has effectively had the opposite effect at the long end (eg 30-year) of the gilt market, which is acting to steepen the yield curve. As I set out in my Decision Time interview with CNBC Opens in a new window, the MPC’s recent decision to slow the pace of QT is effectively an acceptance of this argument.

The MPC’s decision in September attempts to reduce the impact that QT will have at the long end of the gilt market via two key channels. First, over the next 12 months, the BoE will only sell £22bn of its government bonds to the private sector before they mature (a process described as “active” selling) rather than £52bn of active sales that would have to take place if QT were sustained at its previous run-off rate of £100bn a year. Second, the BoE has been clear that the majority of active sales that do occur over the next year will not be at longer-dated maturities of gilts. 

The long end of the gilt market has seen rapid increases in yield recently, with the 30-year jumping by over a full 100 basis points over the past 12 months (see Figure 1). This has been the source of much commentary in recent weeks. It’s important to stress that this dramatic movement in the 30-year gilt yield has mostly related to factors such as fiscal sustainability concerns, inflation risks and a drop in demand for long-dated gilts from pension fund buyers. However, QT may have been somewhat exacerbating the problem, leading the BoE to reduce the level of QT going forward in order to try and minimise its future impact on the gilt market. 

Daniel Mahoney, UK Economist

Sticky UK inflation keeps base rate steady but outlook diverges  from US

September 18 brought the latest rate decision meeting for the Bank of England’s Monetary Policy Committee (MPC), with the consensus for no change being as expected as Daniel explains above. 

The backdrop to the meeting started two days prior with the latest UK labour market data, showing the number of payrolled employees in August fell by less than anticipated, meaning the unemployment rate remained at 4.4% although July’s print was revised slightly downwards to 4.3%. Meanwhile average weekly earnings in July were in-line with expectations at 4.7%, slightly above June’s 4.6% pay growth. The overall sense was that whilst alarm bells are not ringing, the resilient rate of pay growth likely closes the door for further base rate cuts this year. To make matters worse (from an inflation point of view), early estimates for August indicate that median monthly pay grew by 6.6% compared to a year prior.

The following day, September 17 , brought the latest round of inflation data for the UK, coming in largely as expected unmoved from July registering at 3.8% with the core rate of inflation coming in at 3.6%. Services inflation dropped from the y-o-y print of 5% in July to 4.7% in August, in large part due to changes in airfare prices. The downward pressure on the headline rate of inflation from those was partially offset by changes in restaurant and hotel prices as well as motor fuel prices. Oasis’ Edinburgh concert on CPI collection day has even contributed to boosting hotel prices.

That meant market expectations on the morning of the rate decision gave a 0.1% chance of a 25bps cut in September and merely 29% chance of a cut at all by the end of the year, down from a 35% probability priced-in a few days earlier. The actual vote itself showed a split of seven members voting in favour of keeping interest rates on hold, and two voting for a 25 basis point cut, as Daniel discussed earlier. The subsequent comments said that any further rate cuts will be “gradual and careful”. That’s the same wording as has been used since January, suggesting that the BoE doesn’t think cuts are fully done for this cycle, even if the next one may not come until 2026. Despite that, the swaps market only built-in an additional 1% probability of a cut coming at either the November or December meetings, and merely an extra 2bps of cuts over the coming 12-months.

There’s been a sharp widening of the spread between US and UK 10-year sovereign bond yields throughout the last 12-months or so, as Daniel explored earlier, and indeed the difference in interest rate expectations has now broken the recent snug correlation between UK & US 2-year benchmark swap rates (see Figure 2 below), with UK rates steady around 3.75% whilst US 2-years have nose-dived to nearly 3.25%.

A “risk management” cut amidst political pressure and a long-forgotten third objective

September 17 saw the latest US Federal Reserve interest rates meeting, bringing a 25bps cut to the target rate to 4.25% as widely expected, and with hints of more to come in what was described as a “risk-management” cut. 

The morning after the Federal Reserve meeting, swaps markets were pricing in an 88.1% chance of a further 25bps cut in October and 93.0% chance of another 25bps cut in December (a total of 45.3bps priced-in for the rest of 2025) to bring the target rate to 3.75%. For context, the market’s view that the UK’s base rate will most likely remain at 4% over the same period shows why we see the decoupling of swap rates in the two nations.

The latest inflation data doesn’t necessarily seem to support interest rate cuts, with CPI seen to be ticking up to 2.9% in August, the highest since January, after holding steady at 2.7% in both June and July. 

Meanwhile the GDP Price Deflator, the Fed’s preferred barometer of inflation, showed a further estimate of inflation for Q2 down to 2.1% from 3.8% in Q1. The argument for cuts however is put by the second part of the Federal Reserve’s dual mandate — to promote stability in the labour market, after there was a 911k downwards revision to jobs data for the year through to March 2025, showing that the economy is weaker than previously thought. As Chairman Powell put it, “we have a situation where we have two-sided risk, and that means there’s no risk-free path. And, so, it’s quite a difficult situation for policymakers”.

Back under discussion too is the Fed’s third, long-forgotten mandate to pursue moderate long-term interest rates. Whilst explicitly mentioned in the Federal Reserve Act of the 1970s it’s scarcely been mentioned in the decades since. Some argue it’s fulfilment is implied by meeting the other two parts of the mandate: low inflation and maximum employment, whilst others argue it was simply forgotten. Not Stephen Miran, newly-appointed this month to the Federal Reserve Board of Governors (after being nominated by President Trump), who specifically mentioned this third objective during his confirmation with the Senate Banking Committee.

So what is the outlook for long-term interest rates? US 10-year Treasury yields have indeed been ticking up in the latter half of the month but are still around 4.10% (see Figure 3 below). This is lower than they have been since a brief dip in April, suggesting that they may actually have found a bottom and could be set for a sideways move around this level. The trend for 30-year Treasury yields is similar, albeit set about 60bps higher representing a decoupling over the last four months. So far it’s all looking fairly stable without needing further intervention, however whether it is “moderate” or not is very much open to interpretation by the Federal Reserve and perhaps President Trump. 

Eurozone benchmark rates held but French political turmoil problematic for bond yields

September 11 saw the latest ECB meeting, with the decision for no change being exactly as expected (markets were actually pricing in 0.1% chance of a hike in the immediate build-up!). The meeting was followed by a somewhat hawkish press conference, suggesting that further rate cuts are not the central scenario with swaps markets only pricing in 13bps of cuts over the coming 12 months.

Of more immediate concern for eurozone rates markets is the widening gulf between French and German bonds. One of the key worries in financial markets is that France’s re-financing requirements are high, with the rollover of debt in addition to its deficit financing equating to around 20% of GDP, far higher than many other euro equivalents.

Of further concern for French investors is the fact that the yield on 10-year OATs exceeded the yield on 10-year Italian government bonds for the first time in the eurozone’s history (see Figure 4 below), indicating a greater risk premium. 

Three days earlier on September 8, French Prime Minister François Bayrou lost a vote of confidence, as widely expected, and formally tendered his resignation to President Emmanuel Macron the next day. The yield on 10-year OATs had climbed c.9bps on the morning of September 9, however for context the spread over 10-year Bund yields was actually lower than where it was immediately prior to the vote.

Things got even worse after Monday 15 Sep as Fitch cut the country’s credit rating from A+ to AA-, one ranking below the UK and on-par with Belgium, owing to concerns around rising government debt, increased political instability, and doubts about the fiscal outlook. Ongoing concerns around the health of the eurozone’s second-largest economy and the scope of the new government to reduce or increase new debt will be a consideration for the ECB ahead of interest rate decisions. 

Tom Barker, Handelsbanken Markets