Investors’ bets on where UK interest rates will peak have shot higher over the past month, prompting an attempt by Bank of England governor Andrew Bailey to stop markets getting carried away.
Futures markets are currently pricing in a jump in the BoE’s interest rate to just above 4.6 per cent by December. At the start of February, rates were expected to peak at around the current level of 4 per cent and fall slightly by the end of the year as investors worried that the UK was heading into a recession.
That is despite a more mixed bag of UK economic data in recent weeks. Although headline inflation remains in double digits, domestic core inflation — which strips out volatile food and energy prices — declined more than forecast to 5.8 per cent in January from 6.3 per cent the previous month. Business surveys for February, by contrast, showed a faster than expected pick-up in activity.
Bailey pushed back this week against the rapid shift in expectations, arguing that the central bank had “moved away” from a “presumption” that more rate increases were required. His comments led to a small decline in rate expectations, but traders are nevertheless betting that the BoE has become far more hawkish than it was a month ago.
Some analysts argue that markets are overdoing bets that UK rates will follow those in the US sharply higher.
“The consensus view appears to be that the BoE will largely mirror the US Federal Reserve over the next few months”, said Samuel Tombs, chief UK economist at Pantheon Economics. “It often has been a mistake in the past, however, to assume the [BoE] will follow the Fed.”
February’s rebound in UK rate expectations came after a blockbuster US jobs report at the start of February, which shattered the impression of slowing economic activity and hopes of an imminent end to the Fed’s aggressive monetary tightening campaign. Traders spent the next month ramping up their expectations for where US rates might peak.
Bailey’s comments “looked positively dovish”, said analysts at Rabobank, and stood in stark contrast with those from officials at the BoE’s peers in Europe and the US, where headline inflation is lower but proving stickier than previously forecast.
The case for expecting the BoE to stop raising rates soon, and before the Fed, “remains strong”, Tombs said. Rate changes have a “proportionally bigger” impact on activity in the UK than they do in the US, since most UK corporate bank loans are floating rather than fixed rate, and “almost all” UK mortgages have to be refinanced within five years.
These and other differences explain why the Fed last month warned “ongoing increases” would be needed to bring down inflation while the BoE suggested UK rates may have peaked.
Bailey’s comments this week “make clear” the central bank’s monetary policy committee “is placing more emphasis on the substantial tightening already delivered”, Tombs said, though he did not completely rule out the possibility of a further quarter percentage point rate rise later this year.
“In the US, it is rare for Fed officials to leave markets second-guessing its next policy decision,” Tombs said. “But the MPC has a penchant for drama.”