No, this isn’t going to be one of those articles where I try and insert as many song lyrics as possible, but rather an attempt to try to understand the forces shaping the direction of interests rates in the year ahead.
The last 12 months have been a rollercoaster for rates and the start of this year has been no exception, with swap rates rising and then falling over 20bps points in the same number of days, effectively cancelling out and then ‘adding back’ a 25bps base rate cut into the curve.
This volatility shows the real sensitivity of the markets to small changes in UK economic data and the tipping point the UK economy is at presently.
The Bank of England is tasked by the government to get inflation below 2.0%, and is/has been using interest rates as its main mechanism. The unexpected drop in CPI in December and in particular to core CPI now means we look ‘nailed on’ to get a cut to Bank Base when BoE meets on 6th Feb.
As I write (24th January), with two-year SONIA now at circa 4.22%, this is implying not only a cut in February but a reduction mid-year and a cut in early 2026.
SLIPPING FORECASTS
The challenge however is to predict with any certainty a year or even two years ahead – looking at how much swap rates have fluctuated over the preceding two years, is the market likely to be right or even ‘ballpark’ about where bank base ends up? Market forecasts now (which is essentially what a swap rate is) are being made based of data which is changing very rapidly.
As we look ahead, the UK is facing some very unique challenges, all of which have the potential to create a lot of instability and move the rate needle quite quickly. As a result, current assumptions could ultimately end up being quite wide of the mark.
The 18th February will see the release of January’s inflation data. Now, retail sales fell unexpected in December when they were expected to rise, so if the trend continues into January (despite the New Year sales) and CPI continues to fall, the potential for a continued rate-cutting agenda becomes a stronger possibility, potentially bringing forward the next rate cut.
IT’S THE ECONOMY…
In addition, we have the state of the overall UK economy. Growth at best is anaemic and barely above 0.0%. We also still have the impact of the employers’ National Insurance rise to come in at the start of April which will likely have a drag effect on employment and business.
The biggest concern is and should be ‘stagflation’, whereby we achieve little/no growth and have high persistent inflation. We aren’t there yet but one way of potentially avoiding it, if inflation doesn’t quite play ball, is to cut rates as a stimulus, even if we are still above the 2.0% target.
And finally we have the elephant in the room… Trump. The good news I suppose is that we don’t share a land border with the US and aren’t Canada, but even so from a market perspective, Trump is inflationary and, US rates will need to stay higher for longer with the Fed needing to pumping trillions of more debt into the world bond markets. This will ultimately have an impact on gilt yields and, by default, swaps rates over here, particularly at the longer-dated end. Not one for this article perhaps but something to bear in mind.
So, with my crystal ball, where do I think things will end up in a year or so’s time? I, like quite a few commentators, tend to think the markets may have got it slightly wrong based on the way things are looking now. With inflation trending down, and the UK economy continuing to underperform, I think we will start to see more aggressive rate cutting, particularly in the second half of the year.
We have eight BoE meetings between now and year end starting on the 6th February. Assuming, as is the general consensus, we see a 25 basis point cut at this meeting, we will be down to 4.5%. With another rate cut in June (largely assumed/priced by the markets currently), my best guess it that could be in line to get two further reduction in the autumn with a further cut at the start of 2026, bringing us a down to 3.50%.
2025 has a long way to go and it could well be a bumpy ride. Strap yourself in!
