Term Premia Remain Stable Ahead of Expected Rate Cuts

Main points

• The 10-year UK government bond (gilt) yield was on an upwards trend from early 2022 to mid-2023 as a result of the Bank of England’s aggressive monetary tightening cycle, and has since been relatively stable. In the first quarter of 2024, the 10-year gilt yield has fluctuated around four per cent, decreasing slightly from 4.2 per cent in the fourth quarter of 2023, driven by decreasing short-term interest rate expectations. Overall, the UK term premium signals that investors are feeling confident about the path of short-term interest rates
• Given recent CPI inflation data, as well as projections that the CPI inflation rate will fall below two per cent in April, we expect the MPC to start cutting interest rates soon. As noted in this NIESR discussion paper, the MPC could consider publishing a forecast for the path of interest rates in its Reports, as is done in other central banks, such as the Norges Bank and the Sveriges Riksbank. This would help adjust markets’, and the wider public’s expectations, to a particular, but not definite, trajectory of monetary loosening – potentially preventing future volatility in the gilt market
• In the first quarter of 2024, bond market dynamics across the United Kingdom, United States and euro area have been almost identical. This is not surprising given the global integration of financial markets, as well as the similarities in monetary policy tightening cycles and inflationary dynamics in these economies in recent months

“In the first quarter of 2024, the 10-year UK government bond (gilt) yield has fluctuated around four per cent, falling slightly from an average of 4.2 per cent in 2023 Q4. Our decomposition shows that this decrease has been driven by falling short-term interest rate expectations. Overall, the UK term premium signals that investors are feeling certain about the path of short-term interest rates. That said, improved communication from the MPC around any upcoming interest rate cuts may prevent volatility in the term premium in the coming months.”

Paula Bejarano Carbo
Economist, NIESR