What the UK Rate Cut Means for Bond Markets

Based
on
overnight
index
swaps,
the
next
UK
rate
cut
is
expected
by
financial
markets
in
November,
after
the
new
government’s
first
fiscal
event,
the
Autumn
Budget
on
October
30.
While
central
banks
have
got
better
at
communicating
their
intentions
in
recent
years,
policymakers
are
reluctant
to
signal
their
plans
in
advance.
“I’m
not
giving
you
any
view
on
the
path
of
rates
to
come,”
BoE
governor
Andrew
Bailey
said
on
August
1.
In
figuring
out
the
next
move
for
rates,
bond
managers
have
not
only
to
translate
the
messaging
from
central
banks
but
also
compare
these
with
financial
market
expectations,
which
change
daily.
Occasionally
these
are
at
odds
with
each
other.

How
Do
Bonds
React
to
Falling
Rates?

Interest
rates
in
the
US,
Europe
and
UK
are
expected
by
financial
markets
to
fall
further
this
year
and
in
2025,
but
the
timing
and
extent
of
the
cuts
are
unclear.
This
easing
of
monetary
policy
has
been
delayed
in
2024
by
more
persistent
inflation,
but
is
still
seen
as
an
inevitable
process.

UK
government
bond
yields,
as
across
the
world,
have
reacted

in
advance
to
expected
changes
in
monetary
policy.
So,
for
example,
the
2-year
gilt
now
yields
around
3.60%,
whereas
a
year
ago
the
short-term
UK
government
debt
offered
a
yield
of
5%.

Last
year’s
yield
is
more
attractive
of
course
but
the
bond’s

price
moves
inversely
to
the
yield.
Bond
investors
achieve
total
returns
through
yield
and
capital
appreciation
–
so
a
series
of
rate
cuts
would
push
up
bond
prices,
while
weakening
yields.
Some
investors
need
the
income,
but
others
want
income
and
growth
so
are
happy
to
sacrifice
some
yield.

Real
yield
is
an
important
consideration
here
too
–
when
inflation
was
at
10%,
a
bond
yielding
5%
was
superficially
appealing
but
didn’t
beat
inflation.
Now
UK
inflation
is
2%
and
the
benchmark
10-year
gilt
offers
nearly
4%.

Much
depends
on
when
investors
buy
the
bond,
the
price
they
pay
and
rates/inflation
expectations
at
the
time,
as
well
as
whether
they
hold
the
security
to
maturity.
What
remains
“fixed”
over
the
life
of
the
bond
is
the
coupon.

What
Do
Bond
Managers
Think?

Since
rates
were
cranked
up,
cash
and
money
market
funds
have
started
to
offer
attractive
yields
of
around
4%
or
5%.
They
were
seen
as
viable
alternatives
to
bonds
because
they
offered
similar
income,
but
without
the
complexity
of
owning
fixed
income.
Cash
deposits
are
the
ultimate
“safe”
investment
and
offer
greater
capital
protection
than
bonds
–
what
they
can’t
offer
is
capital
gains.

“In
the
period
of
low/rising
bond
yields
and
high
deposit
rates,
this
made
perfect
sense.
Now,
as
we
enter
the
next
phase
of
the
interest
rate
cycle,
this
is
no
longer
the
case,”
says
Colin
Finlayson,
manager
of
the
Gold-rated
Aegon
Absolute
Return
Bond
Fund and
Strategic
Bond
Fund.

He
argues
that
the
market
is
now
at
an
inflection
point
and
investors
could
now
switch
out
of
cash
and
cash-like
instruments
and
back
into
bonds.

“Central
banks
are
now
set
to
cut
interest
rates
and
deposit
rates,
in
turn,
are
set
to
decline,”
he
says
in
emailed
comments.

“At
the
same
time,
bond
yields
are
at
attractive
levels
again,
offering
the
opportunity
for
both
income
and
capital
appreciation.”

While
mortgage
holders
may
want
the
Bank
to
cut
rates
again
quickly
to
make
their
debt
cheaper,
bond
investors
may
have
mixed
feelings.
Despite
the
growing
pressure
on
the
Bank
of
England
to
cut
rates,
August’s
cut
may
actually
have
been
a
mistake,
argues
Neil
Mehta,
who
is
a
portfolio
manager
on
the
BlueBay
Investment
Grade
Euro
Aggregate
Bond
fund,
which
has
a
Morningstar
Medalist
Rating
of
Silver.
There
was
no
“strong
imperative
or
necessity”
to
cut
rates
now,
he
says
in
an
email.

“The
five
MPC
members
who
voted
for
a
cut
may
have
acted
too
hastily,
cutting
for
the
sake
of
cutting,
without
the
data
to
support
the
decision.”

Will
There
Be
More
UK
Rate
Cuts?

Mehta
argues
that
the
latest
policy
move
may
be
“one
and
done”,
and
that
the
Bank’s
scope
for
more
cuts
this
year
are
more
limited
than
markets
are
currently
pricing
in.
The
European
Central
Bank
could
have
set
a
precedent
here
–

the
ECB
signalled
in
advance
that
it
would
cut
in
June,
but
has
since
been
more
cautious
about
the
timing
of
the
next
cut.

September
is
seen
as
the
most
likely
date,
although
recent
inflation
data
has
been
stronger
than
expected.
UK
inflation
is
also
expected
to
rise
again
towards
the
end
of
the
year.

For
UK
debt,
rates
that
are
“higher
for
longer”
would
support
yields
at
current
levels.
Sandra
Rhouma,
European
economist
at
AllianceBernstein,
in
a
note
published
after
the
decision,
said
that
there
will
be
no
dramatic
changes
to
rates
or
yields
in
the
near
term.

“Guidance
indicates
that
rates
will
need
to
remain
restrictive
for
‘sufficiently
long’
to
ensure
inflation
gets
to
target
sustainably
over
the
medium
term.

“This
implies
that
the
BoE
is
not
on
urgent
path
to
neutral
[interest
rates]
any
time
soon.
We
can
therefore
expect
a
rather
gradual
path
in
policy
normalisation
pending
the
data.”

BoE
Should
Cut
Faster

A
contrary
view
comes
from
Harry
Richards,
a
fixed
income
manager
of
Jupiter
Strategic
Bond,
another
Silver-rated
fund.
He
urges
the
Bank
to
get
on
with
cutting
rates
faster
to
spare
the
economy,
which
has
had
to
adjust
to
a
rapid
tightening
in
monetary
policy
since
2021,
since
when
rates
have
gone
from
0.1%
to
5.25%.
Higher
rates
make
borrowing
more
expensive
for
companies
and
consumers.
Critics
of
the
Bank
argue
that
this
has
slowed
down
an
economy
that
has
only
tentatively
escaped
from
recession.

The
BoE
should
loosen
policy
“much
more
aggressively”
into
2025
“to
avoid
doing
irreparable
harm”
to
the
economy
and
the
labour
market
in
particular.
 

On
the
other
hand,
he
thinks
the
new
Labour
government
brings
a
new
air
of
political
stability
to
the
UK,
attracting
overseas
buyers
into
UK
fixed
income.

What
might
this
mean
for
gilts?
As
in
the
scenario
posited
by
Aegon’s
Finlayson
of
rotation
out
of
cash
and
money
markets
to
bonds,
flows
into
UK
bonds
because
of
the
improved
political
situation
could
increase
prices
and
depress
yields.
Rate
cuts
will
have
the
same
effect.
More
buyers
of
fixed-income
instruments
push

up
prices
–
and
this
mechanism
is
explained
in
a
recent
article,
“Want
to
Buy
Government
Bonds?
Be
Careful”.
The
opposite
effect
was
seen
in
the
eurozone
debt
crisis
more
than
10
years
ago:
Investors
sold
out
of
debt
issued
by
indebted
countries
like
Greece,
which
crashed
prices
but
turbocharged
yields.

What
the
Fed
Does
Next

Bond
investors
in
the
UK
may
have
seen
August
1’s
decision
by
the
Bank
as
firing
the
starting
gun
on
a
round
of
rate
cuts,
but
the
picture
is
more
nuanced.
For
global
bond
managers,
much
depends
on
what
the
Federal
Reserve
does
next.
Currently
US
and
UK
interest
rates
are
similar,
5%
and
above,
and
their
bonds
have
similar
yields
too.
Eurozone
debt
yields
are
lower
and
so
is
the
main
interest
rate
at
3.75%.

While
cutting
after
the
BoE,
the
Fed
could
still
cut

more
over
the
next
year
or
so.
Morningstar’s
chief
economist
Preston
Caldwell
expects
US
rates
to
be
around
2%
by
the
end
of
2026,
whereas
UK
rates
are
expected
to
be
around
4%
then.
That
would
shift
the
argument
for
owning
US
debt
over
UK
and
eurozone
debt.
Aegon’s
Finlayson
says
this
makes
it
more
important
to
manage
“duration
risk”,
which
is
the
sensitivity
of
bonds
to
interest
rate
changes.
The
longer
term
the
debt,
the
more
exposed
the
bonds
are
to
this
risk.

Again,
this
is
a
complex
situation
with
many
moving
parts,
including
politics,
credit
ratings,
economic
growth
and
inflation.
Financial
market
narratives
change
all
the
time
–
“lower
for
longer”,
“higher
for
longer”,
“transitory”
versus
“sticky”
inflation
–
and
the
fixed
income
space
is
no
exception.

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