Financial markets are betting the Bank of England will more than double interest rates by May next year as concern grows over further rising inflation in the UK .
The change in expectations in the swap market – which anticipates interest rates of 4% in May compared to 1.75% today – is among the most significant fluctuations in recent years.
The change in expectations, fueled by persistent increases in expected inflation and soaring energy prices, was reflected in other markets. In the UK gilt market, the government’s cost of two-year borrowing has risen by more than a percentage point this month, the biggest rise recorded by Bloomberg since 1992.
Market moves will be reflected in the cost of corporate borrowing and fixed rate mortgages, hurting businesses and households even before the BoE makes interest rate decisions in the months ahead.
Higher borrowing costs will further dampen UK economic activity and the finances of households and businesses which are already suffering from high energy, fuel and food prices – although City economists expect less rate hikes.
Traders in the overnight index swap market, which set prices based on expectations of future official interest rates, are now betting that interest rates will rise to 2.75% by the meeting of November of the BoE before reaching 4% in May.
Separately, the yield on two-year government bonds – indicating the average interest rate over the next 24 months – is now trading at 2.94%, down from 1.83% just a month ago.
“It’s been one-way traffic since the beginning of August,” Matthew Russell, bond fund manager at M&G Investments, said of the gilt moves. “The movements have been excessive.”
Traders grew concerned as UK inflation beat expectations almost every month this year, hitting 10.1% in July.
Russell said Citigroup’s forecast that UK inflation will hit 18.6% next year “has drawn a lot of attention to the [short duration] gilt and which, combined with the situation of the energy markets in Europe, as well as the low summer liquidity on the markets, explain the sharp rise in gilt [yields]”.
As energy prices continue to put pressure on inflation, the new retail price cap for gas and electricity from October to December will be announced on Friday. Analysts expect Ofgem, the sector regulator, to push the annual cost of energy for an average household from £1,971 to over £3,500.
Traders in the government bond and interest rate futures markets pushed interest rate expectations higher with every bad inflation news.
Craig Inches, head of rates and cash at Royal London Asset Management, said the forecast that the BoE would hike rates to 4% was reasonable. “I just don’t see a near-term situation where inflationary pressures are going to subside,” he said.
Financial market forecasts for interest rates reflect comments from the central bank that it would be willing to act “forcefully” if it felt inflation had become entrenched in business and household expectations.
Economists are much less willing to bet on the BoE being so aggressive on monetary tightening. The consensus among city economists is that interest rates will peak at 2.5%, but expectations are changing.
Paul Dales, chief UK economist at Capital Economics, who expects interest rates to hit 3%, said market expectations had “jumped” in recent weeks.
“At this point, I wouldn’t really want to rule anything out,” Dales said. He added that although interest rates of 4% were no longer “completely implausible. . . history shows that markets tend to exaggerate the magnitude of tightening cycles. So at the moment, I feel like the markets have gone a bit too far.”
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