After a bruising week, what’s next for UK markets?

Our analysts share their views on how the latest UK policy moves affect the outlook for markets and interest rates.

The dust may not be completely settled yet, but for now, some sense of calm seems to have been restored. Where do we see interest rates, bond yields, and sterling headed from here? We certainly don’t think the UK is embroiled in a full-blown financial crisis, but it is worth considering some important changes to the outlook.

Sterling has taken a hard pounding, but parity with the USD still looks unlikely

We continue to see dollar-parity as a ‘risk case’ rather than a ‘base case’, even if the pound flirts with (and temporarily touches) those levels. We still think that GBP/USD will be closer to 1.10 than parity by year-end.

Sterling’s fundamentals have deteriorated in recent years, most clearly because of a weaker growth outlook and larger current account deficit funding needs. It’s right that the currency is lower after the mini budget on 23 September, and likely to trade lower yet. But we do not believe we have reached ‘crisis’ levels and nor do we expect to.

GBP/USD depends largely on the US

True, sterling has weakened significantly against the US dollar. But it has performed not nearly as poorly against other currencies (see below). That’s largely because the US dollar is trading at multi-decade highs (an issue for a wide range of countries, not just the UK). So, while the GBP/USD exchange rate may be a concern for UK businesses, wider sterling valuations suggest that the situation isn’t as bad many seem to think.

Key FX forecasts

Sources: Bloomberg, NatWest Markets

That said, for the GBP/USD rate, the outlook heavily depends on the US dollar. Picking the timing of a turn in the US dollar’s strength (driven, we think, by relative economic growth) is arguably more important than sterling-specific fundamentals.

EUR/GBP will likely settle back to lower levels

We are less convinced that the recent move higher in EUR/GBP is fully justified as the focus will now shift to the rest of Europe. There are no easy options for governments. Softening German business sentiment, highlighted by September’s Purchasing Manager’s Index (PMI) figures, hints at the region’s precarious position. Further fiscal policy easing in Europe to tackle high energy prices seems all but inevitable.

How high can the Bank Rate go? Not as high as doomsayers think

Whilst UK inflation is sensitive to the exchange rate, it is far from clear that the inflation impulse from sterling’s depreciation warrants the Bank Rate reaching anything like the 6% markets are currently pricing. We think the Bank Rate is more likely to peak at 4.5% in Q1 2023.

How high would rates need to rise? At the time of writing, sterling (trade-weighted) had fallen by around 3% since the mini budget on 23 September 2022 and by 6% since the August 2022 Monetary Policy Report MPR. We estimate that a sustained 3% fall in sterling might reasonably be expected to boost core price inflation by around 0.5% (and a 6% fall by around 1%) a year or so down the line. That’s clearly not helpful for the BoE, but nor does it necessitate the sort of ‘shock-and-awe’ monetary policy being priced in by financial markets.

Looking at household debt servicing costs, which currently stand at 17.8% of pre-tax income (historically low levels), also provides some guidance on where rates could realistically go. Assuming Bank Rate rises are fully passed through to mortgage borrowers, a rise in Bank Rate to 6.25% would take debt-servicing costs to about 33% – in essence, a debt-servicing burden not seen since the early 1990s boom-and-bust years. Even a Bank Rate rise to 4.5% appears to present a risk of monetary policy overkill (see below).

Household debt servicing costs: actual vs. predicted under different Bank Rate scenarios (% of pre-tax income)

Sources: UK Finance, Office for National Statistics, NatWest Markets

Gilts yields will rise, but the BoE’s intervention doesn’t really affect the medium-term outlook for bonds

Given the significant growth in the supply of Gilts implied by the mini budget, we don’t think the recent spike in Gilt yields – peaking at just above 4.5% for 10-year notes – was divorced from economic fundamentals: the growth outlook, the path for interest rates, and sterling valuations. And although the swift rise in yields spurred the BoE to essentially restart quantitative easing (QE) in a bid to restore market composure, we don’t think it materially alters the medium-term outlook for Gilt yields (see below).

Key FX, Gilt, and Bank Rate forecasts

Sources: Bank of England (BoE), Bloomberg, NatWest Markets

A large part of the re-pricing in yields has been driven by the vast increase in supply of Gilts as a result of the new government fiscal policy. On the other hand, the pace of active Gilt sales through quantitative tightening or QT (around £40 billion) is set to be small in comparison. Even if the BoE were to buy enough bonds in the coming weeks to totally offset the amount of QT over the next twelve months, the net Gilt supply picture is little changed (see below).

Year on year changes in Gilt supply: substantial, with or without active QT (£ billions)

Sources: Bank of England (BoE), UK Debt Management Office, NatWest Markets

Either way, and as we wrote in our previous note, this additional supply is going to struggle to find a home in a high inflation, low growth world. We think that 10-year Gilt yields settling at 5% in the medium-term is more likely than 4%, but the pace of re-pricing to that point may well be more measured than the market moves over the past couple of days.

Get in touch

Login to Market Insights to read the full analysis. Don’t have access? Speak with your NatWest representative or contact us at NatWest Corporates.

This article has been prepared for information purposes only, does not constitute an analysis of all potentially material issues and is subject to change at any time without prior notice. NatWest Markets does not undertake to update you of such changes.  It is indicative only and is not binding. Other than as indicated, this article has been prepared on the basis of publicly available information believed to be reliable but no representation, warranty, undertaking or assurance of any kind, express or implied, is made as to the adequacy, accuracy, completeness or reasonableness of the information contained in this article, nor does NatWest Markets accept any obligation to any recipient to update or correct any information contained herein. Views expressed herein are not intended to be and should not be viewed as advice or as a personal recommendation. The views expressed herein may not be objective or independent of the interests of the authors or other NatWest Markets trading desks, who may be active participants in the markets, investments or strategies referred to in this article. NatWest Markets will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser; nor does NatWest Markets owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on NatWest Markets for investment advice or recommendations of any sort. You should make your own independent evaluation of the relevance and adequacy of the information contained in this article and any issues that are of concern to you.

This article does not constitute an offer to buy or sell, or a solicitation of an offer to buy or sell any investment, nor does it constitute an offer to provide any products or services that are capable of acceptance to form a contract. NatWest Markets and each of its respective affiliates accepts no liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this material or reliance on the information contained herein. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not be lawfully disclaimed.

NatWest Markets Plc. Incorporated and registered in Scotland No. 90312 with limited liability. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and Prudential Regulation Authority. NatWest Markets N.V. is incorporated with limited liability in The Netherlands, authorised and supervised by De Nederlandsche Bank, the European Central Bank and the Autoriteit Financiële Markten. It has its seat at Amsterdam, The Netherlands, and is registered in the Commercial Register under number 33002587. Registered Office: Claude Debussylaan 94, Amsterdam, The Netherlands. NatWest Markets Plc is, in certain jurisdictions, an authorised agent of NatWest Markets N.V. and NatWest Markets N.V. is, in certain jurisdictions, an authorised agent of NatWest Markets Plc. NatWest Markets Securities Japan Limited [Kanto Financial Bureau (Kin-sho) No. 202] is authorised and regulated by the Japan Financial Services Agency. Securities business in the United States is conducted through NatWest Markets Securities Inc., a FINRA registered broker-dealer (http://www.finra.org), a SIPC member (www.sipc.org) and a wholly owned indirect subsidiary of NatWest Markets Plc.

Copyright © NatWest Markets Plc. All rights reserved.

scroll to top