The bank holiday weekend continued to provide reason for markets to price a runaway Bank of England. Come market open on Tuesday, the positioning calling for an over-sized hike from the central bank grew, with rate expectations advancing across the curve. As well as developing interest rate expectations for the meeting later today (scheduled for midday), it is evident the terminal rate, i.e. the peak interest rate that the Bank will hit next year, has increased concomitantly.
The graph below shows how markets, as observed earlier this week, were pricing in the Bank of England’s future path of interest rate policy. Rather than flirting with the 4.5% level as they had been at the start of this month and for most of last month, interest rate expectations are now pricing in more than one full additional 25-basis point hike with a terminal rate of 4.79% from July through November 2023.
Further out into 2025 through to 2027, long term interest rates too are above implied levels observed earlier this month, now settling around 3%. These implied yield curves reflect near-term data and traded contracts. Long term interest rates are therefore less reliable than expectations in the short term. However, the protracted and stubbornly higher implied rates of interest are indicative of an economy expected to experience a structural change in its interest and inflation rate outlooks.
We have spoken recently about today’s Bank of England decision and Friday’s mini-budget as being a test for GBP. In the case of today’s decision, it is a test of the credibility of the Bank of England as a central bank focused and able to effectively tackle and control rising inflation. In the case of Friday’s mini-budget, it is more of a litmus test of just how fiscally profligate will the new government be. Both in turn present a test to the global fixed income and UK gilt market for both domestic and international investors alike. In particular, a test of how willing they are to finance the UK external current account and public deficits by providing ample credit in a time of competitive borrowing. It will be this test that will determine how the forward interest rate curve will look this time next week and in turn impact the fortunes of GBP for the months ahead.
Discussion and Analysis by Charles Porter