Markets gear up for new BoE rates hike

Financial markets are increasingly confident that the Bank of England (BoE) will raise interest rates to a 25-year high of 6.5% at the beginning of next year, surpassing previous expectations of a peak at 6.25%. This development has led to the yield on short-dated government bonds reaching their highest level since mid-2008.

Rate futures indicate a probability of around two in three that the BoE will implement interest rate hikes to reach 6.5% or higher by its February 2024 meeting, compared to the current rate of 5%.

Last month, the BoE acknowledged the persistence of inflation and surprised the markets by increasing interest rates by half a percentage point, a larger increment than anticipated.

Despite these more hawkish actions and recent comments made by BoE Governor Andrew Bailey, the upward trajectory of gilt yields and rate expectations remains unabated.

Deutsche Bank strategists noted in a client memo that investors’ expectations for future BoE rate hikes have become increasingly aggressive in recent days.

Bailey stated on Thursday that there is some evidence indicating that overcharging by certain retailers is contributing to inflation, contrary to the BoE’s previous assessment that such practices were not widespread.

Economists’ forecasts have also shifted upward, albeit at a slower pace. According to a Reuters poll published on June 26, the median forecast for peak interest rates was 5.5%.

A BoE survey released on Thursday presented mixed signals regarding the stickiness of inflation. While businesses’ plans to raise prices were at their lowest in 15 months, with a rate of 5.3%, their expectations for medium-term consumer price inflation rose to a five-month high of 3.7%, surpassing the BoE’s 2% target.

The impact of higher interest rates is already evident in certain sectors. The construction purchasing managers’ index (PMI) reported the largest decline in house building since 2009, with the exception of two months in 2020.

Despite a weaker growth outlook, gilt yields experienced a significant increase across various maturity periods. This contrasts with recent trends where the most substantial movements were observed in shorter maturities.

Ten-year yields reached their highest level since the market turmoil after the September 2023 mini-budget, rising by as much as 11 basis points (bps) to 4.606%. Similarly, five-year yields exceeded that peak, reaching 4.898%, the highest since July 2008.

Two-year gilt yields, which are particularly sensitive to rate expectations, also climbed by as much as 11 bps to 5.488%, marking their highest point since June 2008.

In comparison to US and German government bonds, all gilts underperformed, resulting in spreads against Bunds widening to over 200 bps, the widest since October.