This week has been packed with news: two key central bank meetings, a state visit, and investment pledges totaling approximately £150 billion from US tech giants have heated up UK markets both macro- and narrative-wise. This is juxtaposed with a stark policy divergence: the Federal Reserve has cut interest rates and hinted at a "rapid" pace in the coming months; while in the UK, the consensus view is that a Bank of England rate cut is highly unlikely today (September 18th), with the probability of a rate cut this year at less than 30%.



Analysts point out that this isn't a simple "hawk-dove divide," but rather a divergence in constraints: If policy remains on hold, UK interest rates will remain among the highest in the G10, while coexisting with high inflation in the G20, making it an "outlier for the wrong reasons." To make matters worse, the Office for Budget Responsibility (OBR) is expected to lower its productivity forecasts before the November budget, lowering potential growth and tightening fiscal space, further compressing the scope for alternative monetary policy.

Inflation stickiness and the interest rate path: Why it’s difficult to “give way to growth”

While common sense suggests that rate cuts would improve cash flow discounting and interest burdens, the Bank of England's goal is price stability. Recent data contradict this: August's CPI rose by 3.8% year-on-year, with all price components rising, while none declined. This suggests deflation has stalled and price momentum remains upward. Traders worry that a hasty easing of interest rates could reignite inflation expectations, raising nominal and real term premiums, and ultimately pushing up long-term financing costs, offsetting the marginal benefits of rate cuts.

Regarding the interest rate path, interest rate futures are still pricing in only one rate cut by mid-2026, reflecting the market consensus for a "slow-motion" approach. Regarding the voting structure, a few doves, such as Dhingra and Ramsden, may favor easing, but this is unlikely to change the overall situation. A more likely communication is a reaffirmation of the "meeting-by-meeting" approach and the lack of pre-commitment. While some believe there is an asymmetric risk between "maintaining 4.00%" and "further unexpected rate cuts," given the balance between continued broad-based upward pressure on inflation and a weakening labor market and growth, but not out of control, the preference is for a "stability first, then observation" approach to mitigate the cost of policy misjudgment.

The signal of QT slowdown: the cost of duration respite and fiscal linkage

Equally closely watched as the interest rate level is the pace of quantitative tightening (QT). The prevailing expectation is that the Bank of England will reduce its annual gilt reduction from £100 billion to £70 billion to mitigate upward pressure on long-term gilt yields, which are near 30-year highs. Balance sheet logic suggests that recent declines in bond prices and increases in yields have eroded the book value of bond holdings, while rising interest payments on bank reserves have necessitated offsetting through Treasury transfers. If QT reductions remain insufficient to offset the shortfall, pressure may converge on the Chancellor of the Exchequer in the Autumn Budget, with the possibility of using measures such as a bank levy to offset the shortfall.

In terms of market implications, the shrinking QT volume is beneficial to the long-term duration in the short term and eases the upward trend of term spreads, making the curve more likely to present a "bullish steep" shape; but the redistribution of profits and losses between finance, banks and central banks will flow back in the medium term in the form of uncertainty premium, making the sustainability and magnitude of the downward trend in yields uncertain.

Scenario analysis of the British pound and British government bonds

In terms of exchange rates, the British pound has appreciated 0.9% against the US dollar over the past month, but has fallen 0.3% against the euro. This is driven by a slow rise in the UK yield curve: Over the past three months, the 10-year yield has risen by +7 basis points, the 2-year yield has risen by +3 basis points, and the 30-year yield has risen by +14 basis points, which is more moderate than in the Eurozone. This has resulted in limited spreads, subdued volatility, and a "low-volatility to mid-range" market for the British pound. Based on this, three scenarios are analyzed:



Baseline (highest probability): Unchanged interest rates, emphasis on meeting-by-meeting decisions, and an announcement of a reduction in QT from £100 billion to £70 billion. Duration benefits, the curve is bullish, and the pound remains range-bound, with a relatively passive short-term relationship against the US dollar.

Unexpected easing (low probability): A rate cut without a change in the broad-based nature of inflation. Nominal and real yields may fall first and then rise, with inflation compensation rising; the risk of GBP/USD testing the lower end of its range increases.

More hawkish (low probability): Rates remain unchanged, but QT is not cut, or the language becomes tougher. Long-term interest rates rise again, financial conditions tighten, benefiting the pound in the short term but weighing on overall risk appetite.

External shocks are equally important: both the Bank of Canada and the Federal Reserve have cut interest rates, and the market's previous "implicit bet" on a 50 basis point larger rate cut was dashed, which actually pushed the US dollar to recover.