Rates, FX and gilts

If you are applying to markets, global markets or treasury roles, expect questions on interest rates and currencies. Even for investment banking, knowing how rates affect valuations is a good sign. This lesson covers the UK building blocks: Bank Rate, SONIA, gilts and sterling exchange rates.

Bank Rate

Bank Rate is the Bank of England's main policy rate: the interest rate it pays on reserves that commercial banks hold with it. It is set by the Monetary Policy Committee (MPC), which has nine members and normally announces decisions eight times a year. The government sets the MPC a target of 2% inflation, measured by CPI.

When inflation is too high, the MPC tends to raise Bank Rate. Borrowing becomes more expensive and saving more rewarding, which cools spending and, over time, inflation. When the economy is weak and inflation is low, it tends to cut. Changes pass through to mortgage rates, savings rates, company borrowing costs, gilt yields and the value of sterling.

SONIA

SONIA, the Sterling Overnight Index Average, measures the average rate banks and other institutions actually pay to borrow sterling overnight without collateral. The Bank of England publishes it each London business day for the previous day. It usually sits just below Bank Rate and moves with it.

SONIA replaced sterling LIBOR as the main benchmark for loans and derivatives. LIBOR was based on banks' estimates, while SONIA is based on real transactions, which makes it harder to manipulate. Floating-rate loans and interest rate swaps now usually pay SONIA compounded over each interest period, plus a margin.

Basis points

Rates are compared in basis points (bp). One basis point is 0.01 percentage points, so 100bp is 1 percentage point. If the ten-year gilt yield moves from 4.25% to 4.40%, it has risen by 15bp. Saying "rates rose 0.15%" is ambiguous, because it could mean a relative change, so markets people use basis points.

Gilts

Gilts are bonds issued by the UK government. The UK Debt Management Office, part of HM Treasury, sells them to fund public borrowing. Conventional gilts pay a fixed coupon twice a year and repay £100 per £100 nominal at maturity. Index-linked gilts adjust their coupons and repayment for inflation, measured by RPI.

The yield on a gilt is the return you earn if you buy at today's price and hold to maturity. Price and yield move in opposite directions. If market yields rise above a gilt's coupon, nobody will pay £100 for it, so its price falls until its return matches the market. A gilt whose coupon is above the current yield for its maturity trades above £100, and one whose coupon is below trades below £100.

Duration measures how sensitive a bond's price is to yields. Modified duration tells you the approximate percentage change in price for a 1 percentage point change in yield. Long-dated gilts have high duration, so their prices move a lot. That sensitivity mattered in September 2022, when a sharp rise in gilt yields caused problems for pension schemes using leveraged liability-driven investment strategies, and the Bank of England stepped in with temporary gilt purchases.

The yield curve plots yields against maturity. Short-dated gilts are driven mostly by where markets expect Bank Rate to go. Long-dated gilts also reflect inflation expectations, government borrowing and demand from pension funds and insurers. The gap between conventional and index-linked gilt yields of the same maturity gives breakeven inflation, the market's rough view of future inflation.

The Bank of England also affects gilt yields through its balance sheet. It bought large amounts of gilts under quantitative easing, pushing yields down, and has since been reducing those holdings through quantitative tightening, including by selling gilts back to the market.

Sterling exchange rates

An exchange rate is quoted as base currency/quote currency, showing how much of the quote currency one unit of the base buys. GBP/USD at 1.2700 means £1 buys $1.27. Traders call GBP/USD cable. If GBP/USD rises to 1.2900, the pound has strengthened. EUR/GBP is quoted the other way round, with the euro as the base.

Many things move currencies, but interest rates matter a great deal. If UK rates rise relative to US rates, holding pounds earns more, which tends to support sterling. Surprises count more than expected moves, because markets price in what they expect in advance. Risk sentiment, growth, inflation and politics all play a part too.

Interest rates also set forward exchange rates. A forward locks in a rate for a future date, and it must stop anyone making a risk-free profit by borrowing in one currency and depositing in another. So the currency with the higher interest rate trades at a forward discount: its forward rate buys fewer units of the other currency than spot does. The markets products lesson works through the formula.