- UK and US headline rates now seen reaching 4% by Christmas 2025
- That compares to forecasts of 3.5% just a couple of months ago
- Interest-rate sensitive equity sectors such as real estate, housebuilders and retailers under pressure as a result
- Two-year benchmark government bond yields could be a good guide to what happens next
“It could be down to sticky inflation, worries about government borrowing levels, or the absence of a long-awaited recession, but investors are starting to cut back on the number of interest rate cuts they are expecting from both the US Federal Reserve and the Bank of England,” says AJ Bell investment director Russ Mould. “A month or two ago, markets were pricing in a Fed funds rate and a Bank of England base rate as low as 3.5% by next Christmas, but 4% now seems to be the current consensus for 12 months’ time.
“That implies just three one-quarter point cuts from the current level, which is 4.75% on both sides of the Atlantic after the reductions sanctioned by the UK’s Monetary Policy Committee and the Federal Open Markets Committee at their November meetings.
“The Fed is expected to cut by 0.25% to 4.50% on 18 December but markets seem less convinced the Bank of England will act the following day, as an easing of policy is currently seen as a 50-50 chance, despite last week’s uninspiring print for GDP growth in the third quarter.
Source: Bank of England, US Federal Reserve, LSEG Refinitiv data, CME Fedwatch service
“The good news is that interest rates are still expected to go down, and this is particularly important as stock markets are very much pricing in cooler inflation, a soft economic landing (assuming there is a landing at all) and lower borrowing costs. This script has worked well in 2024, especially as central banks have delivered 167 rate cuts worldwide so far this year, compared to just 26 increases.
Source: CBRates
“Looser monetary policy is seen as boosting demand for credit and thus firing up end demand for goods and services, to the benefit of growth.
“Lower headline interest rates also usually mean lower government bond yields, as existing stock on higher coupons is bought and prices rise, while new issue can also come with lower coupons. Those lower yields on fixed-income instruments in turn increase the relative appeal of other asset classes, notably equities.
“That is how the theory goes, at least. However, government bond yields have shrugged off interest rate cuts and gone higher, as can be seen by looking at benchmark 10-year Treasuries in the USA and 10-year gilts in the UK.
Source: LSEG Refinitiv data
“In the US, this could be a reaction to sticky inflation, which has not come in at or below the Fed’s 2% target since February 2021, concern that the economy may overheat in the event of generous Trump tax cuts, or fears about a huge onrush of supply of Treasuries as America continues to rack up huge borrowing numbers. In the UK, bond vigilantes’ concerns probably focus on UK government borrowing in the wake of October’s Budget, where Chancellor Rachel Reeves’ rewriting of the fiscal rules and determination to invest for growth means forecasts for the supply of gilts are on the rise. The UK’s track record of paying its coupons and returning principal on time ever since 1672 means it will always be able to find buyers for new gilts, but it may come down to a matter of price – and the lower the price investors are prepared to pay, then the higher the coupon the gilts must offer to tempt buyers.
“While the 10-year issue is the benchmark for the risk-free rate, and the yield off which all other debt instruments (and asset classes) are priced, as well as other forms of loans such as mortgages and credit cards, it is the two-year that has an uncanny record of moving before central banks.
“Right now, the UK two-year yield is 4.39% and the US equivalent 4.28%. If markets are right that central banks will take their headline borrowing rates to 4.00% by Christmas 2025, that implies interest rate increases are coming in 2026.
Source: LSEG Refinitiv data
“That does not really fit with equity markets’ preferred narrative, and it probably is not ideal for the UK or US economies either, given what higher borrowing costs would mean for governmental interest bills.
“Some share prices are starting to listen to the bond markets, however.
“Sectors that are seen as bond proxies, such as utilities, are coming under a little pressure. Here, in many (but not all) cases, the companies carry a lot of debt. Moreover, they tend to be valued on the basis of their dividend yield, as they are not expected to offer much by way of earnings growth given tight regulation and the relatively stable nature of demand. The higher bond yields go, the less attractive utilities’ dividends look by comparison (and vice-versa).
Source: LSEG Refinitiv data
“Housebuilding shares have crumbled again in the UK. Retail stocks have also lost momentum, perhaps for fear of what higher borrowing costs could do to consumer sentiment and spending patterns come 2026, although these labour-intensive businesses may also be assessing the more immediate challenge posed by the higher wages and increased national insurance contributions stipulated in the Budget.”
Source: LSEG Refinitiv data
