Bond Watch: why rates fell but gilt yields rose

The Bank of England cut interest rates this week from 4.25% to 4%, with five of the nine members of the Monetary Policy Committee (MPC) voting to reduce the Bank Rate.

However, the market didn’t expect four of the MPC members to vote for no change in interest rates. It was therefore a “hawkish” cut, causing investors to price in higher interest rates for longer. Gilt yields therefore rose slightly after the announcement – the 10-year UK gilt now yields 4.57%.

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Vivek Paul, UK chief investment strategist at fund manager BlackRock, said: “The Bank’s decision to cut rates came as no surprise for markets. But the path from here is less certain, highlighted by Thursday’s knife-edge vote. Inflation remains sticky: pay growth is easing but is still too high for inflation to settle at the Bank’s 2% target.”

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The big concern for bond investors is that inflation remains high (it is currently at 3.6%), even as the economy weakens. The Bank of England thinks that inflation will peak at 4% in September before falling back to its 2% target. In its meeting note, the Bank of England said that “upside risks around medium-term inflationary pressures have moved slightly higher since May”.

The MPC said that the timing and pace of future reductions will depend on the extent to which underlying disinflationary pressures continue to ease.

BlackRock thinks there will be two more 0.25 point cuts before the end of 2026, but then not much more beyond 2026 unless there is a “rapid deterioration in growth”. This means that interest rates are expected to be higher for longer.

An even bigger black hole

A report this week from the National Institute for Economic and Social Research (NIESR), which is a highly regarded economics think-tank, found that Chancellor Rachel Reeves would need to raise an additional £41.2 billion in the Autumn Budget to meet her target of balancing the budget by 2030.

The “black hole” rises to £51 billion if Reeves is to have the same fiscal headroom she had during her Spring Budget.

The think-tank said that slower economic growth and greater borrowing means that the chancellor will need to cut spending or raise taxes, or both, if she wants to balance the books.

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The easiest way to do so would be to raise taxes on working people, such as income tax or employees’ national insurance, however, she ruled this out in the Labour election manifesto. Labour has also struggled to cut its welfare bill, which indicates that cutting other parts of government spending will also be difficult for the party.

Fiscal challenges for the UK government are not positive for gilts, as they likely lead to more borrowing. Investors will therefore demand higher yields, which leads to existing bond prices falling.