Markets price in UK interest rate of 6.5% by next March

Expectations rise sharply to anticipate highest borrowing costs since 1998
Investors are betting that UK interest rates will climb to 6.5 per cent by March next year — the highest level since 1998 — in a move that will heap even more pain on mortgage borrowers.

The peak in UK interest rates priced by swaps markets has risen dramatically in recent weeks, from 5 per cent as recently as May to 6.25 per cent following the Bank of England’s unexpected decision to raise interest rates to 5 per cent in June.

“There’s a self feeding dynamic here . . . but it’s not a panic yet,” said Peter Schaffrik, economist at RBC Capital Markets.

“As rates are going higher, those people who thought yesterday that rates were too high and were opposing more increases — they have to throw in the towel and as they do that rates go higher”.

Bank of England governor Andrew Bailey told the BBC on Thursday that he wanted to get inflation “back to where it needs to be and then we can assess what level interest rates should be at going forward”.
“I understand very much the difficulties that people face,” Bailey added. “Unfortunately this is how we have to get inflation down. If we don’t get inflation down, it gets worse and we’ll have to put up interest rates more.’’

Imogen Bachra, head of UK rates strategy at NatWest, said the market had taken this as a “green light to price in ever more rate hikes”.
Headline prices rose 8.7 per cent in the year to May, with core inflation, which strips out volatile food and energy prices and which is viewed as a better indication of underlying price pressures, accelerating ahead of expectations to 7.1 per cent.

Benchmark two-year gilt yields, which are highly sensitive to interest rate expectations, rose by 0.08 percentage points on Thursday to 5.46 per cent, the highest level since 2008. The average five-year fixed-rate UK mortgage has already risen above 6 per cent.

Last week, JPMorgan economist Allan Monks said in a note to clients that the BoE could be forced to push rates as high as 7 per cent if inflation proved even more stubborn than expected, although his central expectation remained that rates would peak at 5.75 per cent in November.

While rate expectations have risen, sterling has weakened in recent weeks, from a peak of $1.2838 per cent in June to $1.2708 on Thursday.
Analysts highlighted this as a concern because in an environment where interest rate expectations are rising compared with other countries, sterling should be strengthening. The UK is expected to increase rates by more than the Federal Reserve and the European Central Bank.

Lyn Graham-Taylor, a senior strategist for Rabobank, said that sterling had failed to strengthen because “rate rises are not a function of economic strength — they are a function of inflation being worse in the UK than other places”.
“A lot of it is an ‘I don’t want to touch sterling’ trade’ — it’s uncertainty over the future.”