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Investors are now speculating that UK interest rates could reach 6.25% by early next year, the highest level since 1998. This comes as the Bank of England intensifies its efforts to combat inflation.
The BoE surprised the market by increasing its benchmark borrowing rate by 0.5 percentage points to 5%, surpassing the anticipated 0.25 percentage point increase. The decision was influenced by the latest inflation figures, which showed a stubborn 8.7% inflation rate in May, far exceeding the central bank’s 2% target.
Analysts believe that this forceful response from the BoE indicates that interest rates will continue to rise aggressively until there is a significant decline in consumer price rises. Swaps markets now imply an interest rate of 6.25% in February, whereas just last month, rates were expected to peak at less than 5%.
“For the Bank to slow down, we would need to see a significant drop in inflation or a significant drop in the labor market, and neither is likely to occur in the near future,” said Peter Schaffrik, economist at RBC Capital Markets. He added, “I understand why the market believes they will continue raising rates in half-percentage point increments.”
Jordan Rochester, a senior G10 FX strategist at Nomura, stated that the Bank of England is now making interest rate decisions based on the latest inflation data, similar to how the Federal Reserve operates.
These actions by the BoE followed Governor Andrew Bailey’s refusal to challenge previous market predictions that interest rates would peak at around 6%. Bailey emphasized that the central bank is willing to take necessary measures to bring down inflation.
As a result of these developments, short-term UK government bonds, which are sensitive to rate expectations, experienced a decline. The two-year gilt yield increased to 5.18%, the highest level since 2008.
The growing expectations of higher interest rates add pressure to UK mortgages, which are influenced by movements in the swaps market. UK mortgages have already been referred to as a “time bomb.”
It is worth noting that while rates are expected to rise, the value of the pound has not strengthened. This indicates that investors are concerned about the negative impact higher borrowing costs will have on the economy.
On Friday, the pound declined 0.4% against the dollar, extending the previous day’s decline.
Further weakening of the pound, which leads to higher costs for imported goods, could pose a challenge for the BoE in its battle against inflation.
Rochester described the decline in sterling following the rate announcement as “the market’s way of expressing a high risk of a negative outcome in the future.”
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