Inflation will stay higher for longer and the labour market will remain tight into 2023, which suggest the Bank of England base rate will rise to 3% next year.

This is above the current 2.5% being priced into markets, and the 2% peak expected by economist consensus, according to Capital Economics (CE).

Gilt yields and corporate bonds

With its more hawkish forecast for the bank rate, it has revised up its forecast for gilt yields, with 10-year yields rising from 1.84% to 3% by mid-2023.

It noted that the sell-off in government bonds has continued this month and the 10-year gilt yield rose above 2% last week for the first time since before the Brexit vote in 2016.

Paul Dales, chief UK economist at CE said: “Government bond yields have climbed as real yields have been driven higher by rising interest rate expectations. The Bank of England’s quantitative tightening may mean long-dated yields rise the most.”

He added: “Corporate bond spreads will probably widen a bit further as the economy weakens. But as we are not expecting a recession, we doubt that spreads will surge.”

FTSE 100 and UK equities

Given the prospect of weaker economic growth and higher interest rates, CE has revised down its equity price forecasts.

The FTSE 100 has fallen nearly 1.5% in the past month but it has been more resilient than both the S&P 500 (-8%) and the Dax 30 (-4%).

“Robust performances in sectors like utilities and healthcare have supported UK equities. But the bigger help has come from the weaker pound, which has boosted the foreign earnings of firms in the FTSE 100.

“Indeed, the FTSE Local has been hit much harder. In fact, in sector-neutral common currency terms, the FTSE 100 has actually underperformed the S&P 500,” Dales said.

He added: “We think the recent fall in UK equities has further to go as the effects of higher inflation, weaker economic growth and higher interest rates are felt.

“We expect the FTSE 100 to fall from 7,550 now, to around 7,250 by the end of this year,” Dales added.

But on a more positive note, Dales said the firm expects the FTSE 100 to outperform the S&P 500 from 2023 onwards.

“That’s mainly because we think it will be more resilient to higher interest rates, given that – even after accounting for compositional differences – UK equities trade at a big discount to US equities. That underpins our view that the FTSE 100 could rebound by 8% in 2023 and by 10% in 2024, compared to 6% and 6% for the S&P 500,” he said.

Sterling against the dollar and euro

Turning to sterling, Dales explained that because of the negative shift in investor sentiment, along with the trade shock from the war in Ukraine which weighs on the pound, it has also revised down its forecast for the currency.

CE noted that the fall in sterling has been more pronounced than the fall in the euro, “perhaps reflecting sterling’s greater sensitivity to investor risk appetite”. Sterling dropped 5% from $1.30 to a recent low of $1.24 since 20 April 2022.

Dales said: “Sterling has weakened sharply against the dollar as investor sentiment towards risky assets has soured and amid worries the war in Ukraine will weaken economic growth in the UK by more than in the US.

“We think the pound will weaken from $1.26 now to around $1.22 by December. But this may reverse from 2023 onwards as global risk sentiment recovers and inflation falls back in the UK.”

He added that against the euro, CE thinks the pound may appreciate from €1.19 to €1.22 by the end of 2022 “in light of Europe’s larger terms of trade shock and our relative bond yield forecasts”.