Markets overdo higher for longer narrative

While expectations for interest rate cuts in the UK have been pared back in recent months amid growing inflation concerns in the US, we think the markets have gone too far in concluding that UK interest rates will still be as high as 4.00% by the end of 2025. We think that the legacy of the weaker UK economy will mean that inflation in the UK falls further than in the US and that this may be one of those rare occasions where the Bank of England cuts interest rates sooner and further than the Fed. (See here.) Our forecast that Bank Rate will fall from 5.25% now to 3.00% in 2025 explains why we think 10-year gilt yields will decline from 4.30% now to around 3.25% this year and the pound will weaken from $1.25 now to around $1.20. Meanwhile, we expect further AI enthusiasm will drive the FTSE 100 from its current record high of just above 8,100 to about 9,300 in 2025. That all said, the risks are skewed towards interest rate cuts happening a bit later and more of the falls in gilt yields and the pound taking place in 2025 rather than in 2024.