Rate decision: BOE to balance uncertain politics, struggling households and a bearish bond

By Gaël Fichan, head of fixed income at Syz Group

The Bank of England (BoE) will reveal its latest policy decision this Thursday, expected to maintain interest rates at 5.25%. Investors are on edge, anticipating potential rate cuts as early as August due to mixed economic signals.

Inflation is gradually improving, yet the economic landscape remains unpredictable: while services are rebounding, manufacturing is cooling, and unemployment is rising. The previous 8-1 vote to hold rates may now become a more divided 7-2.

UK government bonds are grappling with “bear steepening,” where long-term yields rise faster than short-term ones. This has led to one of the worst starts (-5% in 2024 so far) in UK bond market history, with the 2-year yield now at 4.4% and the 10-year yield rising to 4.2%. Furthermore, over the past four years, UK bonds have experienced a significant -31% decline in total returns.

On Thursday, the BoE will also provide its economic and interest rate forecasts. With inflation edging closer to the 2% target and a terminal rate now expected at 3.75%, markets are closely watching for signs that the BoE will open the door to rate cuts before August. There’s significant interest in whether the BoE will hold on to its projections of 0.25% GDP growth in 2024 and 2.75% inflation by the end of the year or revise them for a stronger recovery.

The BoE’s actions are closely tied to the Federal Reserve, and the timing of potential rate cuts relative to the Fed will be crucial. This relationship will also affect the GBP/USD exchange rate, which has fluctuated due to the economic challenges both economies face. 

Political uncertainties add to the complexity, as a possible Q4 2024 election with a Labour majority could reshape fiscal policies and the BoE’s approach. Additionally, fixed-rate mortgages, which have supported household finances during tightening, may complicate the BoE’s easing cycle. Declining household net interest income may necessitate deeper rate cuts to counterbalance. 

Ultimately, the BoE must balance inflation control with stimulating economic growth, as its decisions will have significant implications for stabilizing the economy and navigating the uncertainties of 2024. Investors will closely monitor how the BoE aligns its strategy with global trends while managing the volatile UK bond market.