Bank of England interest rates unlikely to reach 4.75% by next summer, say City economists
City economists expect Bank of England interest rates to rise far less than financial markets price, with only about 50 basis points of genuine hikes pencilled in by some banks, against market pricing that implies 4.75% by the end of July.
Bank of England interest rates unlikely to reach 4.75% by next summer, say City economists
Financial markets imply that Bank of England interest rates will be raised at least four times over the coming year, lifting the bank rate from 3.75% to 4.75% by the end of July and possibly to 5% by December 2027. City economists think that pricing is wrong, because there is little sign that the rise in energy costs is pushing up other prices sharply.
What the markets are pricing
Market-implied interest rates are worked out from the prices of a range of financial instruments, including derivatives such as swaps, to establish where traders expect rates to sit in future. On that basis, markets currently imply at least four increases over the next year, with the bank rate at 4.75% by the end of July and a possible peak of 5% by December 2027.
Why economists disagree
James Smith, developed markets economist at ING, said the swaps market has four increases followed by no cuts, a view he doubts many share.
"you've got four rate hikes and then no cuts ever. And I think you'd be hard-pressed to find anybody that really agrees"
Sanjay Raja, Deutsche Bank's chief UK economist, has calculated that much of the forecast rise in market-implied rates is risk premia. Once that is stripped out, his estimate is that only about 50 basis points of genuine hikes are pencilled in. Deutsche Bank's base case is for the bank rate to reach 4.25% by next February and then hold until the end of 2027.
Raja said that, on today's information, he does not believe any mainstream forecaster thinks the Bank of England will hike to 5% by the end of next year, though it could happen.
Oil prices and reluctant traders
One reason market-implied expectations have climbed so high, economists say, is that they have been closely correlated with oil prices since the Iran war began. That link keeps the pricing elevated even though forecasters question it.
Traders who doubt the pricing face practical obstacles to betting against it:
- If rates do not rise as far as markets price, but oil prices keep increasing in the meantime, they would face mark-to-market losses and potentially margin calls.
- Smith said many traders were burnt at the start of the current Middle East crisis, when most were positioned for further rate cuts this year.
- He added that a lot of traders are reluctant to take the risk of betting against the pricing until there is greater certainty about energy supply and inflation this winter.
Where the forecasters stand
The immediate fixed point is the Bank's next meeting on 5 November, where a rise to 4% is widely expected. That follows UK inflation rising further above its target in September, to 3.5%.
The major forecasters are all well below the market path:
- Goldman Sachs said last month that its probability-weighted forecast path for the bank rate remained "notably below market pricing", though it expects a rise to 4% next month.
- Morgan Stanley's base case is rises in November and February, with rates on hold thereafter, but it sees additional pressure to raise interest rates if the Low Pay Commission recommends a larger increase in the national living wage than expected.
- Oxford Economics forecasts 25 basis point rises at the November and February meetings, taking the bank rate to 4.25% - significantly below the peak in money market expectations of 4.75% to 5%.
Even inside the Bank there is scepticism. Huw Pill, the Bank's chief economist, told an IMF meeting in Bangkok this month that he was sceptical the Bank would need to raise interest rates four times over the next year.
Smith thinks that by next spring the Bank could be sounding the all clear, and that it could be cutting rates again by the end of next year.
