Global Capital Flows and the Sterling Rate Path: A Macro Analysis

The dominant macro trend of the past year has been a powerful, sustained flow of global capital into U.S. assets. This shift has reached a new peak, with foreign holdings of U.S. Treasuries hitting an all-time peak of $9.355 trillion in November. The surge represents a 7.2% year-on-year increase, underscoring the enduring appeal of dollar-denominated safe-haven securities.

This record high marks a clear reversal from a brief period of weakness. Holdings had declined for two consecutive months earlier in the year, a move that reflected heightened market uncertainty. The recent uptick is directly linked to improved sentiment following the resolution of the longest-ever U.S. federal government shutdown. As political stability returned, capital flowed back into the Treasury market, reinforcing its role as the world's primary liquidity pool.

At the top of the foreign ownership hierarchy are Japan and China. As of August 2023, Japan held approximately $1.116 trillion, while China held roughly $805 billion. These positions, while subject to month-to-month fluctuations, illustrate the structural scale of foreign investment in U.S. debt. The continued accumulation by these major central banks and official institutions is a key pillar supporting the dollar's global reserve status and funding America's fiscal deficits.

The Domestic Driver: Bank of England Policy and the Sterling Curve

The Bank of England's policy path is now a story of measured easing and internal division. In its final decision of 2025, the MPC cut its benchmark rate to 3.75% from 4%, marking the sixth reduction since August 2024. The move, however, was not unanimous. It passed by a 5-4 split, exposing deep uncertainty among policymakers about the pace of further cuts. The central bank acknowledged that policy has already become "significantly less restrictive" after a 150-basis-point decline, but emphasized that judgments on future easing would soon become a "closer call."

The official outlook points to a gradual downward trajectory. Governor Andrew Bailey has projected that inflation, which stood at 3.2% in its latest reading, could reach the 2% target as early as April or May. This forward guidance, echoed by policymaker Alan Taylor who sees inflation hitting target in mid-2026, suggests the BoE is positioning for a normalization of monetary policy. Yet, the market's interpretation of this setup is nuanced and, for now, optimistic.

Despite the rate cut, the shape of the sterling yield curve tells a more complex story. While long-dated gilt yields have fallen, 5-year sterling yields are underperforming the broader curve. This divergence is a classic signal of market optimism about the economic cycle. When investors push back expectations for near-term rate cuts, they are effectively betting that growth, while muted, is not deteriorating into a sharp downturn. This dynamic has already pushed the probability of a March rate cut down to just 9 basis points priced in, as the market looks ahead to a more stable, albeit still soft, recovery.

The bottom line is that domestic monetary policy is easing, but the market is already looking past the next cut. The BoE's cautious, divided approach is being met with a forward-looking assessment that sees inflation returning to target without triggering an aggressive policy response. This sets the stage for a yield curve that continues to trend lower, but with the near-term path for rates more uncertain than the data alone would suggest.

The Interplay: How Global Flows Shape Domestic Policy

The Bank of England's path is no longer set in isolation. Its decision to cut rates to 3.75% from 4% last month was framed as a move on a gradual downward path, contingent on inflation normalizing. Yet this domestic policy calculus is now being influenced by a powerful, external current: the record flow of global capital into U.S. assets. This dynamic creates a complex feedback loop that will shape both the pace of UK monetary easing and the trajectory of the domestic economy.

The surge in foreign demand for U.S. Treasuries, which hit an all-time peak of $9.355 trillion in November, supports a stronger dollar. A resilient greenback makes UK exports more expensive abroad, acting as a persistent headwind for the domestic economy. This dampens export competitiveness and could exert upward pressure on import prices, complicating the BoE's task of bringing inflation down to its 2% target. In this context, the central bank's cautious, divided approach to further cuts is understandable-it must balance easing domestic borrowing costs against the risk of a weaker pound fueling inflation.

Domestically, the impact of the BoE's cut is already visible in the housing market. Major lenders have responded by cutting mortgage rates, with the average five-year fixed deal dropping to 5%. This move, coupled with the highest number of mortgage products in 18 years, is fueling expectations of a "booming market" in 2026. The housing sector, a key driver of consumer spending, appears poised for a rebound as financing costs fall.

The bottom line is a world of interdependence. The BoE's gradual easing is predicated on a domestic inflation story that is being influenced by global capital flows. At the same time, the resulting drop in mortgage rates is stimulating domestic demand. The central bank's challenge is to navigate this dual pressure: supporting growth through lower borrowing costs while ensuring that the external forces of a strong dollar and global risk appetite do not derail its inflation target. The market's forward-looking assessment of the economic cycle, as seen in the underperformance of 5-year sterling yields, suggests it is already weighing these competing forces.

Catalysts and Risks: The Path Forward for Sterling Rates

The immediate test for the BoE's easing path comes with the release of its February Monetary Policy Report and minutes. This report will provide updated inflation forecasts and the committee's forward guidance, offering a crucial data point on whether the central bank's internal divisions are resolving. Markets are already pricing a gradual descent, with a 78% probability of a cut to 3.25% by November. Yet this trajectory hinges entirely on the evolution of price pressures and the labor market.

The primary risk to this forecast is a resurgence in services inflation. The latest data shows services inflation at a still-hot 4.4%. If this figure rises further, as some analysts warn, it would signal that underlying price pressures are not being fully tamed. This could force the MPC to delay cuts, causing a sharp repricing of sterling yields as market expectations for a dovish cycle are reset. The committee's caution, underscored by a 5-4 split decision last month, suggests it is prepared to wait for clearer evidence that inflation is sustainably returning to target.

In the near term, the jobs market will be a key indicator. Economists note that lingering weakness in the quantities side of the labour market could elicit a more dovish reaction from the BoE. Conversely, a stronger-than-expected jobs report could push back expectations for a March cut, which is now priced at just 9 basis points. This tension between inflation data and labor market signals will define the volatility in sterling yields over the coming months.

The bottom line is that the path for sterling rates is being set by a delicate balance. The BoE's policy is guided by domestic data, but its room to maneuver is constrained by global capital flows that support a strong dollar. The February report and the subsequent data will determine whether the central bank can maintain its gradual easing course or if it must pause to confront persistent inflation. For now, the market's optimism about the economic cycle, reflected in the underperformance of 5-year yields, remains a fragile but forward-looking bet.