Bond Watch: key takeaways following latest interest rate decisions

Over the past week or so we’ve seen the latest interest rate decisions across the pond and in the UK, with both outcomes widely expected.

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On these shores, the Bank of England’s Monetary Policy Committee (MPC) took the expected decision to hold rates at 4%. However, the vote was much closer than anticipated. The MPC was split 5:4 in favour of a hold on rates at 4%.

Bank of England Governor Andrew Bailey wishes to see “durability” in disinflation later this year before continuing cuts. The four in favour of a 25 basis points cut cited the downside threats to demand, materialising employment risks as well as the progression in disinflation – CPI in September surprised to the downside by remaining at 3.8% year-on-year. Gilt yields across the curve marginally dropped following the announcement.

The predicament facing the MPC is tough. The UK stands out amid the G7 with the highest inflation rate and still significant upward price pressure across certain sectors (transport and food to name two) affecting consumers and hampering the path to easing. Yet signs of weakness in the labour market, subdued economic growth, as well as the potential uncertainty associated with fiscal policy upcoming in Labour’s Autumn Budget later this month, muddy the path ahead for the Bank.

• Bank of England chooses caution ahead of Autumn Budget
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In the US (last week on 29 October), the Federal Reserve lowered its benchmark interest rate by 25 basis points to a range of 3.75%-4% – a decision that had been clearly anticipated by markets, with futures in the days prior predicting the cut with around 98% probability. The decision had only two dissenters out of its 12 voting members, one of whom voted for a 50 basis points cut and one for a hold.

How bond markets responded

As the Federal Reserve lowered its benchmark rate, short-term yields briefly rose before settling, reacting in part to Fed Reserve chair Jerome Powell’s cautionary comments on the prospect of a further cut in December.

September’s 3% CPI reading remains above target, but Powell’s focus increasingly has been on the downside employment risks since job creation revisions in the second quarter.

With inflation described by Powell as “somewhat elevated” and a labour market deemed to be “gradually cooling”, the most recent Federal Reserve dot plot (quarterly chart of interest rate projections by Federal Reserve officials) makes gradual cuts in 2026 look likely. However, the CME’s FedWatch tool (based on activity of rates traders) still favours another cut in 2025, with a 67% probability.

While bank rates in the US and UK are similar, both countries face fiscal challenges. Moreover, there is plenty of uncertainty – underscored by a potentially seismic Budget in the UK, and a now record-length government shutdown in the US.

However, the factors that will drive monetary policy differ. The Federal Reserve navigates a slowing employment picture but a more moderate inflation issue and a still solid economic growth rate.

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In a perhaps less enviable position, the UK’s Bank of England faces inflation near twice the target rate amid weaker growth and, in the words of MPC member Alan Taylor, “weakening demand and low confidence”.

While in press statements Powell and Bailey have increasingly emphasised the risk to the downside in making interest rate decisions, the Bank of England may have less room for manoeuvre than the Federal Reserve, forced to balance the need to rein in stubborn inflation against the risk of further dampening an already fragile economy.

In the near future, in the UK, particularly sticky inflation could result in less downward pressure on yields of short-dated bonds if the anticipated disinflation fails to bring inflation anywhere near to target and rates don't fall. With yield curves acutely upward sloping in both the UK and US, long-dated bonds are higher reward but also substantially higher risk.

On the one hand, a downward labour market and/or growth shocks in theory could lead to price appreciation for long-dated bonds if investors reassess long-term rate assumptions. However, mounting fiscal pressures and sticky inflation threaten to keep long-term yields elevated or cause them to rise further still.

More risk-averse investors likely will prefer to lessen duration risk (sensitivity to interest rates) by seeking out fixed-income exposure towards the short end of the bond curve - a safer option in the near term.

Options include L&G Short Dated £ Corporate Bond Index I Inc fund, which invests in short-dated company bonds with less than five years to maturity, which tend to be less sensitive to changes in interest rates than longer-dated bonds.

A strongly performing active fund in this space is the abrdn-Short Dated Enhanced Income X MInc Hdg GBP fund, which invests predominantly in US dollar-denominated corporate bonds, but also has some exposure to sterling and the euro. The fund has a maximum portfolio duration of two years (currently 1.5 years).