Why the dip in UK yields may have run its course

UK 10-year bond yields have fallen more than 30bp since mid-October, on renewed hopes that the Bank of England can cut interest rates this year, together with greater confidence that the Autumn Budget in late November will deliver a market-friendly outcome.

Rewind one month and markets were deeply sceptical that the Bank of England would cut rates again, and certainly not this year. But that's changing. Inflation, at 3.8%, appears to have peaked. And while it’s unlikely to fall much before next year, there are more encouraging signs beneath the surface.

Food inflation – a particular bugbear at the BoE – fell in September and is now running half a percentage point below official forecasts. Similar evidence from the eurozone hints that price pressure in supermarkets may be passing its worst.

Service sector inflation is easing too; we calculate that “core services” is now below 4%. That’s helped by private sector wage growth, which is also on track to end the year below 4%, having started 2025 at 6%.

For now, that better inflation news is largely confined to one month’s worth of data. But we’ve long felt that the BoE’s concerns about another inflation wave are overblown. We expect headline inflation to dip back from 3.8% today to the 2.5% area next spring. And that’s why we expect Bank Rate to fall to 3.25% by next summer.

If that happens, that would be welcome news for Chancellor Rachel Reeves. In fact, the recent fall in gilt yields should already shave £5bn off the size of her fiscal hole, relative to where we were a few weeks ago. That’s assuming the Office for Budget Responsibility incorporates these latest market moves in its forecasts.

Still, sizeable downgrades to productivity growth likely mean the chancellor faces a shortfall of roughly £25bn/year – and more if she wants to leave a bigger fiscal buffer than she had back in March.

That is well recognised now, and increasingly so is the combination of measures that are likely to fill the gap. The chancellor is likely to extend a freeze on tax thresholds beyond 2028, extend National Insurance to landlords/partnerships, and hike a range of smaller taxes on the likes of banks, pricier properties and dividends.

Assuming that’s the case, we don’t think gilt yields have much further to fall, if at all. Bank of England expectations, which have driven that move lower in yields, are more or less in line with our own forecasts. Another modest leg lower is possible should the chancellor go further, by breaking with her manifesto pledge not to hike income tax. We suspect Reeves can restore the necessary fiscal headroom without doing that.