FICC - Summer 2024 Navigating the Political Economy: The UK’s Financial Outlook

Gilt Performance:

Since reaching a 2024 high of 4.49% on May 20th, 10-year Gilt yields have experienced a prolonged decline as inflationary concerns continue to diminish. After the annual inflation rate remained at the 2% target in both May and June the Monetary Policy Committee voted 5-4 to lower the UK bank rate by 25 percentage points to 5% on August 1st. Subsequently, 10-year Gilt yields fell below 4% by August 2nd, the first time since February, and reached a low of 3.93% by August 14th. In terms of further bank rate cuts, the Bank of England did emphasise their vigilance about second-round inflationary effects but Governor Andrew Bailey later stated that the effects appear “smaller than we expected”.

Declining UK 10-Year Gilt Yields Between June and August

Bank of England Inflation Forecast

Expectations of lower GDP growth have also contributed to the decline in Gilt yields. GDP grew by 0.7% and 0.6% in Q1 and Q2 respectively, which marked the highest quarterly growth rate since 2022. The services sector exhibited the strongest growth at 0.8% in Q2, with widespread growth across the sector, while both the production and construction sectors declined by 0.1%. However, growth is forecast to fall back to 0.4% and 0.2% in Q3 and Q4 respectively as fiscal policy is expected to tighten. This strengthens the case for the Monetary Policy Committee to stimulate the economy with further bank rate cuts.

Bank of England GDP Growth Projection

The trajectory of GDP growth remains the most significant factor shaping the outlook for 10-year Gilt yields. While there is broad consensus that the upcoming Autumn budget, to be delivered by the Chancellor of the Exchequer on October 30th, will involve fiscal tightening, the nature and severity of policies remain unclear. Consequently, although we expect the Monetary Policy Committee to further lower the Bank Rate to support GDP growth, the exact timing and extent of the adjustment remains uncertain. This uncertainty suggests that we may see significant fluctuations in 10-year Gilt yields following the budget announcement. However, with the Federal Reserve expected to lower US interest rates at its September meeting, alongside an appreciating GBP, UK Gilt yields may decline in the near term as British securities become increasingly attractive in comparison.

GBP Performance:

The GBP depreciated against its major trading partners after the August 1st Monetary Policy Committee meeting due to uncertainty regarding whether the UK bank rate would be lowered. Markets had only priced in less than a 60% chance of a cut upon the announcement of the 25-percentage point reduction and the GBP subsequently depreciated against the USD from $1.28 to $1.27 by August 6th, while it depreciated against the EUR from €1.18 to €1.16 in the same period.
Thereafter, the GBP began to recover ahead of the Jackson Hole Economic Symposium which took place between August 22nd and August 24th. Here, US Federal Reserve Chairman Jerome Powell clearly expressed that “the time has come for policy to adjust”, citing falling inflation and a cooling labour market. Meanwhile Phillip Lane, European Central Bank Chief Economist, conveyed greater vigilance about further rate cuts. The GBP subsequently appreciated against the USD to $1.32 by August 24th, its highest level since March 2022, while it only recovered to the August 1st rate of €1.18 against the EUR.

USD per GBP and EUR per GBP between June and August

General Election:

Sir Keir Starmer became the UK’s prime minister after the Labour Party achieved a majority victory in the 2024 general election, ending 14 consecutive years of Conservative rule. At 412, Labour more than doubled their seats from 201 in the 2019 general election, while the Conservatives only won 121 seats. Following the election on July 4th, the GBP appreciated against the USD from $1.28 to $1.30 by July 12th, while it appreciated from €1.18 to €1.19 against the EUR in the same period. Meanwhile, 10-year Gilt yields fell from 4.31% to 4.21% by July 12th and continued to a low of 3.93% by August 14th.

The UK’s government debt stood at 97.60% of GDP in the 2023-2024 financial year, over 10% higher than the pre-pandemic level. The Labour Party is built upon traditionally central-leftist ideologies and, speaking on August 27th, Sir Keir Starmer has already warned of a “painful” October budget as markets anticipate higher taxes. This incentivises the Monetary Policy Committee to further lower interest rates such that we may expect both lower bond yields and a weaker GBP.

Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute financial advice. Readers should not interpret any information provided here as specific guidance for financial decisions. Always consult with a qualified financial advisor before making any investment or financial choices.