A Delayed Landing For GBP Rates

(MENAFN- ING)

We expect domestic factors to pull rates lower in 2027, but global factors will continue to push gilt yields around. In our baseline forecast, we see the 10yr gilt yield easing lower as ugly inflation fears abate. The Bank of England could start considering rate cuts instead of more hikes. Looking back at the many global drivers pushing GBP rates around in 2026, we do think that the path lower will be volatile.

Easing UK inflation should bring rates lower, but global factors add volatility Source: ING, Macrobond

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The Bank of England's policy rate is already much higher than those of its peers, which leads us to disagree with the significant amount of additional hiking priced in by markets. Forwards are now suggesting the Bank of England should hike at least 100bp, bringing the terminal rate to around 4.75%, above what markets are pricing for the Fed. The hawkish pricing already happened at the start of the surge in oil prices, but thus far, few rate hikes have materialised.

Markets keep overestimating the Bank of England's appetite to hike Source: ING, Bank of England, Macrobond

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The excessively hawkish reaction feels like a trauma from being too dovish over the past few years. When we compare market pricing to actual policy changes, we see that expectations have been almost consistently wrong since 2023. Past inflation was, however, uglier than expected, easing more slowly than hoped. As a consequence, the Bank of England has only been able to cut policy rates very slowly since the easing cycle started in 2023.

Investors have been burnt many times on taking dovish GBP rate positions Source: ING, Bank of England, Macrobond

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Having been burnt many times over the past year, we think the front end of the GBP curve has built in a risk premium that stretches beyond macro fundamentals. We therefore see 2yr GBP rates easing lower into 1H27 as energy prices should start coming off their highs and inflation doesn't surprise to the upside. But the bigger dovish turn will likely come in the second half as inflation numbers provide greater confidence about returning to the 2% target.

US rates add additional uncertainty to sterling rates

US dynamics cannot be ignored and should eventually also help sterling rates glide lower. The 10yr GBP swap rate can be modelled almost perfectly by Bank of England expectations and the US swap curve. These factors together explain some 98% of rate moves.

Two US ingredients are important: the level of the 10yr rate and the 2s10s slope of the curve. Our baseline forecast sees materially lower 10yr US rates, helping the 10yr gilt move lower in 2027.

Policy expectations and US rates account for 98% of 10Y GBP swap moves Source: ING, Macrobond

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But the US is facing inflation risks and a high deficit, adding uncertainty to the gilt outlook. If US inflation turns out to be more persistent than hoped, we could see the 10yr USD swap rate push toward 6%, spilling over to the sterling market. Similarly, concerns about global government debt and AI issuance can add to the upward pressure on global rates.

Changes in QT won't stem the upward pressure on rates due to supply

While we think the UK is in a better position than most peers when it comes to "bad" government deficit and debt dynamics, supply pressures will continue to exert upward pressure on gilt yields. Thus far, the Bank of England has more actively reduced its balance sheet, adding to the supply for the private sector to absorb. Earlier this year we estimated that quantitative tightening (QT) added significant steepening pressure to sterling curves – more so than the Bank of England suggests.

The new approach to QT should ease the upward pressures on 30yr gilts, but the broader outlook remains the same. By keeping gilts on the balance sheet with maturities of 23 years or longer, markets no longer have to worry about absorbing that part of the curve. Having said that, the rise in 30yr yields is a global trend and not something on which the UK has a lot of influence.

Meanwhile, shorter maturities will still hit the market, albeit with a detour through the government Debt Management Office (DMO). The DMO could decide to shift gilt issuance to bills, but we doubt such a strategy will be pursued. Add a persistent budget deficit, and we should see supply pressures persist.

QT tweaks help 30yr gilts, but cannot revert a global trend of increased bond supply Source: ING, Macrobond

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The increased gilt supply is currently absorbed by relatively price-sensitive buyers. This increases upward yield pressure and can come with volatility. Banks are only absorbing part of the increase in supply, while insurance and pension funds are playing a smaller and smaller role, which is especially punitive for longer maturities. Foreign investors and other financials (i.e. asset managers, hedge funds) are picking up the slack. But these types of investors are more relative-value-focused and can be quick to sell if gilts start looking less attractive.

Gilts rely on price-sensitive buyers to pick up the increase in supply Source: ING, UK Debt Management Office

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