Investors increase bets for higher UK interest rates

Investor expectations of UK interest rate increases have soared this week after stronger than expected data on jobs and inflation. This puts the markets at odds with Bank of England messaging that the cycle of hikes is nearing its end.

The market is now pricing in three additional rate hikes, which will reach a maximum of around 5 per cent by September. This is a dramatic increase from the 4.6 per cent that was expected last week, before figures showing persistently high inflation surprised the market this week.

In March, the UK’s annual consumer price increases did not fall below double-digits at 10.1%. Core inflation — which excludes volatile energy and food prices — was unchanged at 6.2%.

The market has underestimated inflation. When you examine the labour market, which may not be a source for inflation today but will be in the near future, the strength of the labor market is also higher than expected, said Peter Schaffrik. RBC Capital Markets increased their forecasts this week for increases in BoE rates.

According to Office for National Statistics figures released this week, average earnings, excluding bonuses, rose 6.6% year-on-year, a higher rate than the economists’ forecast of 6.2%.

RBC expected that the central bank would hold rates during its next meeting. However, it has now increased its forecast for a 0.25-point rise in May. Schaffrik stated that a terminal rate of 5% was “not impossible”, as the employment data in both the US and Europe were strong and banking concerns have faded.

In recent weeks, the yield on government 10-year debt also increased, rising from 3.4% at the start of the month to 3.8% on Thursday. This is due to expectations that rates will rise.

The price changes have occurred despite recent statements from BoE policymakers that the end of monetary tightening is near, now that interest rates are at 4.25 percent.

Andrew Bailey, the bank governor, said in an early March speech that he believed financial markets were mistaken to think there was a pressing necessity for many rate increases. He warned markets not to adopt a strong stance, and stated that the BoE is now in a wait-and see mode. The BoE had changed its stance from “further increases to the [benchmark] Bank Rate would be required”.

Huw Pill said that the BoE needed to use “judgment”, and not to consider stronger economic activity as necessarily inflationary, because the reversal in natural gas prices meant better economic data wasn’t “something intrinsically inflationary”.

He said that the BoE still needed to prove it had done enough to combat inflation. However, his comments did not indicate a willingness to increase rates to 5%.

The market’s expectations of rate increases have increased this week. However, the timing for expected rate reductions has not changed much. Markets are still pricing rate drops at the end of the year.

Imogen Bachra of NatWest’s UK rates strategy said that it was “unlikely”, the BoE will cut rates as quickly as the market anticipated, given “more evidence” of stronger inflationary pressures and “relatively muted risks in the financial systems compared to those of other countries, as well as the fact the the hurdle for easing is higher now than in previous cycles.

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