Traders ramped up bets for further Bank of England interest-rate hikes after another shock inflation reading, pricing the benchmark reaching a level last seen before the turn of the century.
Money markets shifted Wednesday on the back of a report showing inflation remained higher than expected for a fourth month. Traders now expect the BOE’s key rate to reach 6% by December, and see a one-in-four chance it will be raised further to 6.25% by February, which would be the highest since 1998.
Gilts tumbled as trading kicked off in London.
The UK has already been through the quickest tightening cycle in 40 years, and lifting the rate to 6% would add to the pressure on borrowers, deal another blow to the housing market and raise questions about the outlook for the broader economy. The BOE on Thursday is expected to raise rates by 25 basis points to 4.75%, though the risk of a half-point increase is growing.
Bloomberg Economics — which believes the market pricing is overdone — forecasts that such a scale of monetary action would send the UK into a shallow recession. Gross domestic product would shrink about 0.3% this year and 1.4% in 2024, according to its SHOK model.
“Higher inflation, higher growth. It’s not a good reason to own gilts,” said Kim Crawford, global rates portfolio manager at JPMorgan Asset Management, adding there’s a compelling case for a half-point hike on Thursday. “Recession is going to be required to get this inflation under control.”
Many households are already struggling because of the cost-of-living crisis, and an additional squeeze, plus worries about the economy, would add to the political headaches for Prime Minister Rishi Sunak. He says his focus is on lowering inflation. On Tuesday, Chancellor of the Exchequer Jeremy Hunt ruled out special mortgage support because it would only exacerbate price growth.
The last time traders were so hawkish on the outlook for interest rates was in September, when former prime minister Liz Truss shocked markets with huge spending plans. But sticky inflation and a tight labor market have led them to ramp up tightening bets once again, in contrast with their peers in the US and the euro zone, where policymakers are seen nearing the end of tightening cycles.
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The shifting outlook further inverted the UK yield curve, suggesting the market is more concerned over the growth outlook and expects rates to fall well into the future. The 10-year yield is now almost 70 basis points below its two-year peer, the most since 2000. Just a month ago, bets were on a terminal rate below 5%, a level still seen as the most likely by economists surveyed by Bloomberg.
The market wagers on additional BOE hikes contrast with expectations for the Federal Reserve and the European Central Bank, with at most two more quarter-point increases expected.
“The UK is in a situation that is worse than Europe and the US, the risk of inflation expectations de-anchoring is the highest in the developed world,” said Raphael Gallardo, chief economist at Carmignac Gestion SA. “The Bank of England has to keep hiking.”
(Adds latest market pricing, analyst comment.)