Navigating the bumps: markets, the budget and the UK outlook

In the last Rate Wrap we pointed out that since the onset of the US-Iran war, the UK economy has shown unexpected resilience. However, there is no getting away from the fact that the rest of this year looks exceptionally challenging. 

Much attention is now naturally being given to the budget on 28 October and the backdrop looks bleak. Oil prices have hovered around the $100 mark throughout September while gas prices are more than double their pre-war level, which will likely end up pushing inflation above the 4% mark (Ofgem announced a 16% increase in the price cap for January 2027 – the largest in 4 years). Moreover, government borrowing costs are reaching alarming levels: as of 28 September, the 10-year gilt yield is sitting at around 5.4% compared to the previous OBR assumption of around 4.5%. 

Note: Dotted lines show gilt yield levels assumed at the previous OBR review

The government appears unlikely to announce any material measures to curtail spending, so not for the first time there is growing speculation about what tax increases might be announced given fiscal headroom has been squeezed. There has been speculation, for example, relating to targeted industry taxes (e.g. a further levy on oil and gas exploration), changes to capital gains tax or lowering the threshold for the upcoming mansion tax. The prospect of a third tax-raising budget in a row clearly raises concerns about whether consumer and business confidence will be damaged, which has prompted Andy Haldane, former chief economist of the Bank of England, to call for a three-year moratorium on further tax rises. 

We only have to look back to the mini-Budget debacle in 2022 to know what could go wrong if the budget on 28 October is not viewed as credible by markets. So the risks of getting this budget wrong are crystal clear but it is worth emphasising that the pressure on sovereign debt markets is certainly not unique to the UK at the moment. Indeed, since Andy Burnham entered Downing Street, there has in fact been a narrowing of spreads between UK gilts and other G7 markets, especially French Oats and US Treasuries. In summary, risks in the government bonds space are rising across the board. 

Moreover, it is notable that our latest Global Macro Forecast Opens in a new window assumes that 2027 and 2028 will see modest growth (1.2% in 2027 and 1.4% in 2028) with inflation elevated but on a declining trajectory. Why? Primarily because we project that geopolitical risk will eventually recede over the coming months, which would prompt a major fall in energy prices and government bond yields. We, of course, saw this happen in mid-June when there was a provisional ceasefire deal signed between the US and Iran. 

The Bank of England held base rate in September but a hike in interest rates is now just around the corner. Financial markets appear to be baking in an assumption that current levels of elevated geopolitical risk remain in place into the medium term but, as we disagree with this judgement, our forecasts very much diverge. Markets currently price in over four rate hikes in the next year while Handelsbanken’s latest forecast points to one rate hike at the next meeting in November but an improving outlook in 2027 ends up allowing for a couple of rate cuts in late 27/early 28. 

I will leave you with an analogy that I have been telling clients over the past couple of weeks. John Healey is driving a car and he is about to approach an almighty speed bump, which has grown over the past couple of weeks. There is a non-negligible risk that he ends up wrecking the car as he hits the speed bump, but we judge that he will just about manage to clear it with the car intact. As geopolitical risk recedes, the road ahead has some potholes and is not especially well maintained but it is certainly drivable. And a couple of years hence, the tarmac may even become smoother and better to drive on, as the UK potentially reaps the benefits of AI adoption. So, just maybe it’s not all doom and gloom? 

Daniel Mahoney, Senior Economist, UK

Central bank messaging reinforces caution

September proved significant for global rates markets, particularly in the UK. The Bank of England left bank rate unchanged at 3.75%, but surprised markets through changes to its quantitative tightening programme. By retaining £120bn of gilts maturing in 2049 or later, the bank eased supply pressure for longer maturities. The response was immediate: 30-year gilt yields fell 12bp on the day, their largest one-day decline since May, while 10-year gilt yields declined by around 6bp.

Despite the hold, the accompanying rhetoric was hawkish. Policymakers warned that higher energy costs risk becoming embedded in wages and broader pricing behaviour, even though current data show limited evidence of this. Governor Bailey, alongside Claire Lombardelli and Sarah Breeden, highlighted concerns around the energy outlook should tensions in the Middle East persist. Against this backdrop, markets now assign an 85% probability of bank rate rising to 4% in November.

The day before the Bank of England’s decision, the Federal Reserve delivered a widely anticipated 25bp rate increase and signalled further tightening ahead. The latest dot plot showed the median forecast implying another increase in 2026, supported by 12 committee members, while four members favoured 50bp of additional tightening by year-end. Fed Chair Kevin Warsh again refrained from contributing to the dot plot, although he characterised the latest move as "removing a dose of accommodation".

The initial market reaction post both meetings was positive, with market rates falling across the curve after the Fed meeting - perhaps down to market fondness of central bank proactivity - whereas the BoE QT overhaul helped longer term UK rates especially. But this ‘dose’ of good news is overshadowed by a sharp repricing of rates higher across the curve throughout the month.

The front end of the UK curve has borne the brunt of September's adjustment. Markets now anticipate at least 1% of additional tightening over the next year. The 2-year SONIA swap rate rose from below 4.4% at the start of the month to briefly above 4.8%, driven by resilient economic data and, more importantly, rising energy prices that have revived concerns over second-round inflation effects. At the time of writing, the UK swap curve traded flat at elevated levels, with 5-year SONIA swap rates rising around 30bp and 10-year rates increasing by just under 20bp.

Energy prices drive market sentiment

Energy markets have been a key driver of September's repricing. Brent crude rose from around $91/bbl to a peak of $109/bbl during the first half of the month as supply disruptions persisted across the Middle East. The expanding conflict involving Saudi Arabia and the Iranian-backed Houthis which has damaged regional infrastructure and reduced traffic through the Bab-al-Mandeb Strait all contributed to tighter supply conditions. President Trump's exploration of a diesel export ban has added further market dislocation.

Natural gas markets followed a similar pattern, with European benchmark prices reaching their highest levels since early 2023 before easing towards month-end. However, storage levels remain below seasonal norms and forecasts continue to point to elevated energy costs through the winter.

Taken together, the sharp rise in short-term rates suggests a market increasingly concerned not only about inflation itself, but also about the risk of central banks responding too slowly, as many believe occurred during the 2022-23 inflation shock. The Federal Reserve's limited forward guidance has arguably amplified this uncertainty, contributing to greater volatility across global rates markets. At present, central banks are likely to be comfortable with tighter market pricing, as it effectively delivers some of the tightening work for them. Whether these expectations prove justified remains to be seen, but the messaging from major central banks throughout September has reinforced their commitment to maintaining price stability.

Curve dynamics shift at the long end

The impact has not been confined to the UK. In the US, 10-year Treasury yields moved decisively above 5%, while 30-year Treasury yields reached their highest level since 2004. Meanwhile, 10-year German Bund yields climbed to their highest level since 2009, underlining the global nature of the sell-off.

At the longer end of the curve, a clear catalyst is still required to bring yields materially lower. Such a trigger could come from a resolution in the Middle East that eases energy prices and inflation concerns, or a more extreme scenario whereby central banks force an inverted curve by having to raise rates significantly and quickly, hitting economic growth hard. For now, the combination of elevated inflation expectations, fiscal concerns and higher global yields continues to keep longer-dated rates under pressure despite the support provided by the Bank of England's QT adjustment.

Focus turns to the October budget

Attention is now turning to Chancellor Healey's first budget on 28 October. Fiscal developments have become an increasingly important driver of UK rates markets and recent history suggests investors are likely to remain cautious in the run-up to the announcement.

Ahead of the October 2024 budget, swap rates rose by 30-40bp across much of the curve over the preceding two months as investors reacted to concerns around borrowing requirements and inflationary fiscal policy. Before the March 2025 Spring Statement, 30-year yields rose around 25bp in the month leading up to the event. 

Volatility was also elevated ahead of the November 2025 budget, partly reflecting the reversal of Chancellor Reeves’ plans to increase income tax, which pushed gilt and swap rates higher before budget day. Each episode demonstrated the sensitivity of the gilt market to changes in fiscal expectations and government supply dynamics, although recently markets generally stabilised in the immediate aftermath of the fiscal event once policy clarity emerged.

The fiscal backdrop today appears at least as challenging. Borrowing during the first five months of the fiscal year exceeded official forecasts, with the cumulative deficit reaching £77.3bn, around £8.1bn above OBR projections. This has reduced fiscal headroom and increased speculation over the measures required to rebuild credibility and maintain adequate buffers. The government's apparent reluctance to signal policy intentions in advance has added to this uncertainty, although expectations remain centred on a series of targeted tax increases designed to rebuild part of/all the lost fiscal headroom.

While further volatility ahead of the budget cannot be ruled out as additional information emerges, the risk of significant market disruption afterwards appears limited. Healey is likely to be acutely aware of the importance of maintaining market confidence (even if PM Burnham’s comments suggest otherwise) and avoiding any perception of fiscal complacency.

In summary

As we approach Q4, September has reinforced two key themes for UK rates markets. Inflation risks remain concentrated at the front end of the curve, where expectations for further policy tightening continue to underpin yields. At the same time, supply dynamics have become increasingly important at the long end following the Bank of England's intervention. With both monetary and fiscal policy firmly in focus, these factors are likely to remain the dominant drivers of market performance through year-end.

Cameron Willard, Handelsbanken Markets