UK markets were slightly weaker this week, with the FTSE 100 Index down 0.2% to 10,720 points at the time of writing. The outlook for interest rates remains uncertain, with differing views over how the Bank of England (BoE) should respond to persistent inflationary pressures and the impact of higher energy prices.
The Organisation for Economic Co-operation and Development (OECD) said the BoE does not need to raise interest rates further, arguing that monetary policy is already sufficiently restrictive to keep inflation under control. In its interim economic outlook, the OECD said the BoE could keep interest rates at 3.75% well into 2027 before potentially cutting them by 0.25% in the third quarter.
This contrasts with recent guidance from BoE Governor Andrew Bailey, who warned that interest rates may need to rise if inflationary pressures persist. Markets are currently pricing in four 0.25 percentage-point increases by the end of next year. UK inflation rose to 3.1% in August, remaining above the BoE’s 2% target. However, the OECD lowered its forecast for UK inflation in 2026 to 3.1%, from 3.7% in June, and expects inflation to fall further to 2.6% in 2027.
It noted that a decline in energy prices could reduce the risk of so-called second-round effects, where higher energy costs feed through into wages and broader corporate pricing. Conversely, if oil and gas prices remain elevated, the OECD said the UK central bank will need to keep policy unchanged. Economic activity also showed signs of losing momentum.
The S&P Global Flash UK Purchasing Managers’ Index fell to 51.7 in September from 52.5 in August, although a reading above 50 still indicates an expansion in private-sector activity. Businesses cited high energy prices, elevated borrowing costs and uncertainty ahead of the Budget as factors weighing on activity. The OECD expects the UK economy to grow by 1.1% this year and 1% in 2027, compared with 2.2% growth forecast for the US this year.
Fiscal pressures remain another challenge. Government borrowing rose to £18.3 billion in August, £3.5 billion above the Office for Budget Responsibility’s forecast, as higher inflation increased public spending and debt-interest costs. Borrowing for the financial year to August reached £77.3 billion, around £8.1 billion above the OBR’s March forecast.
Public sector net debt stood at £2.985 trillion, equivalent to 93.8% of GDP, while central government debt-interest payments reached £8.8 billion in August, the highest figure recorded for that month since records began in 1997, reflecting the impact of inflation on index-linked bonds. With the Budget scheduled for 28 October, the combination of above-target inflation, elevated borrowing costs, subdued economic growth and higher government borrowing continues to provide a challenging backdrop for UK policymakers.
Commodity markets
In the commodity markets, Brent crude futures traded around $105 per barrel on Friday, easing considerably after a two-day rally as investors assessed the possibility of renewed diplomatic progress between the US and Iran. Reports suggested that the two countries are considering a phased agreement that could reopen the Strait of Hormuz and lead to the lifting of the US blockade on Iranian ports.
Tensions between Washington and Tehran have remained elevated this week. Speaking at the United Nations General Assembly, Iranian President, Masoud Pezeshkian accused the US and Israel of contributing to global instability and said Iran would continue to defend itself. However, oil prices fell towards the end of the week after a senior Iranian official indicated that allowing navigation through the Strait of Hormuz in exchange for an end to the US naval blockade could represent the most realistic path towards de-escalation.
The proposed framework reportedly resembles a memorandum of understanding agreed between the US and Iran in June, although that agreement subsequently broke down amid renewed fighting. It remains unclear whether the latest discussions can overcome the obstacles that caused the previous agreement to collapse. According to Al Jazeera, Iran is seeking a return to the terms of the memorandum before the US midterm elections.
Meanwhile, investors are also monitoring signs of continued strength in Asian oil demand. The region is expected to import around 23.96 million barrels of crude per day in September, according to data compiled by Kepler and reported by Reuters. This would represent an increase from 23.38 million barrels per day in August and the highest level since February.
Gold prices traded around $4,280 an ounce on Friday and are set to post a weekly loss, pressured by a stronger dollar and growing expectations that the Federal Reserve will keep interest rates elevated to contain inflation.
Equity markets
US equity futures edged higher on Friday despite a continued rise in Treasury yields. In Thursday’s regular trading session, the Dow Jones Industrial Average fell 0.31%, the S&P 500 declined 0.02%, while the Nasdaq Composite was broadly unchanged, gaining 0.01%.
Attention remained firmly focused on the bond market, where yields continued to move higher. The yield on the US 10-year Treasury climbed to 5.225% late on Thursday, its highest level since 2007, while the 30-year yield reached 5.502%.
The latest rise in yields was driven by a combination of factors, including hawkish comments from Federal Reserve Governor Michael Barr, elevated energy prices linked to geopolitical tensions involving Iran, and stronger-than-expected economic data.
Economic indicators released this week pointed to continued resilience in the US economy. The S&P Global US Flash Composite PMI rose to 58.4 in September from 56.0 in August, signalling the strongest expansion in private-sector activity since July 2021 and marking a fourth consecutive month of accelerating growth. The service sector led the increase, recording its fastest pace of output growth in more than five years, while manufacturing activity also improved. Demand conditions remained supportive, with new orders increasing at a faster rate, primarily driven by domestic markets. However, stronger activity was accompanied by renewed inflationary pressures. Input costs rose at the quickest pace since October 2022, reflecting higher fuel and transport expenses, while many businesses also reported rising wage costs. These developments may reinforce expectations that interest rates could remain elevated for longer if inflationary pressures prove persistent.
On the geopolitical front, Chinese President Xi Jinping arrived in Washington this week for a high-profile summit with US President Donald Trump. Ahead of the meeting, US Treasury Secretary, Scott Bessent confirmed that the United States and China had agreed to extend their existing trade truce until 10 January, delaying the expiry of the arrangement that had previously been due to end in November. The extension of the trade agreement offers a degree of stability for global markets at a time when investors are also navigating higher bond yields, geopolitical tensions and evolving monetary policy expectations.
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