Odd one out?

Which of the big three Western central banks is seen as most likely to have to reverse their pending rate cuts? In other words, which is expected to preside over the most V-shaped interest rate outlook – the Fed, the European Central Bank (ECB) or the Bank of England (BoE)?

It's not the one currently expected to deliver the sharpest cuts from today's levels: that would be the Fed, where money markets are effectively expecting a cumulative drop of roughly 2.5 percentage points from today's levels to 2026's projected lows. The ECB, which has admittedly already cut a cumulative 0.5 percentage points since May, is expected to deliver around a further 1.8 percentage points to 2026; the BoE, which has cut by 0.25 percentage points since July, is also expected to cut by a further 1.8 percentage points or so.

Nor is it the one expected to deliver the lowest rates: that would be the ECB, where rates are expected to trough at around 1.6%. US rates are seen bottoming at 2.8%, and UK rates at 3.2%.

Instead, if you look at the forward interest rates priced into government bond markets – that is, at the string of short-term interest rates implicitly embedded in government bonds of varying maturities – then it's the Bank of England. The implied short-term rates priced into gilts are back close to current levels by the mid-2030s. Similar US and euro area forward rates are also expected to back up, but not so markedly.

We shouldn't read too much into this. The expectations priced into bonds are the result of market positioning, the underlying motives for which are ultimately unknown, and the forward rates derived from government bond markets can spiky.

It could be a technical kink, for example. Gilt yields dip from today's one-year yield of 4.2% to a three-year yield of 3.5% before rebounding to a 20-year yield of 4.3%: low-coupon issues around the three- to five-year maturity may simply be particularly prized (UK gilts are exempt from capital gains tax). The V-shape is less pronounced in ‘purer’ – though less accessible – money market curves based on derivatives.

But the profile is arguably consistent with a longer-term view of the UK's prospects. The UK has always had the most ingrained inflationary tendencies; its central bank has perhaps looked the least hawkish throughout the recent inflation cycle; and there is a new government with potentially expansionary ambitions in place (once the initial, ground-zero-establishing budget is out of the way in late October).

This does not mean, by the way, that we share the concerns of the UK Office for Budgetary Responsibility about UK creditworthiness: we showed last year that its long-term fiscal analysis can be needlessly pessimistic. But the inflationary consequences of fiscal expansion in today's fully-employed UK economy might be more significant for rates and yields.

Our own, qualitative interest rate views do not necessarily align with bond markets' implied forecasts. Forward curves took a took a long time to adjust to the earlier low-rate environment, and were then slow to respond when rates actually did begin to rise. Currently, we think those projected rate cuts for the US are once again looking excessive, for example.

But unscrambling the yield curve into its constituent forward rates does often provide food for thought, and in signalling the eventual re-emergence of higher yields in the UK they could be onto something. Watch this space.