Markets bet on Bank of England rates hitting 25-year high of 6.5%

Financial markets bet on Thursday that the Bank of England will raise interest rates to a 25-year high of 6.5% early next year, up from a previous expected peak of 6.25%, pushing the yield on short-dated government bonds to their highest since mid 2008.

Rate futures showed a roughly two in three chance that the BoE will have raised rates to 6.5% or higher by its February 2024 meeting, up from 5% now.

Last month the BoE said there had been “more persistence in the inflation process” and raised interest rates by a bigger-than-expected half a percentage point.

The more hawkish shift and comments last week by BoE Governor Andrew Bailey have done nothing to stem an upward climb in gilt yields and rate expectations.

“Investors’ expectations for future BoE hikes have only become more aggressive in recent days,” strategists at Deutsche Bank (ETR:DBKGn) wrote in a note to clients.

Bailey said on Thursday there was some evidence that overcharging by some retailers was contributing to inflation. The BoE previously said this was not widespread.

Economists’ forecasts have also moved up, though more slowly. A Reuters poll published on June 26 showed a median forecast of rates peaking at 5.5%.

A BoE survey on Thursday gave mixed messages on inflation stickiness. Businesses’ plans to raise prices were the lowest in 15 months at 5.3%, but their expectations for consumer price inflation in the medium term rose to a five-month high of 3.7%, well above the BoE’s 2% target.

The impact on higher interest rates on some parts of the economy is already clear, with a construction purchasing managers’ index (PMI) recording the biggest fall in house building since 2009, bar two months in 2020.

Despite the weaker growth outlook, gilt yields rose strongly across a range of maturities, in contrast to a recent trend where the biggest moves have been for shorter maturities.

Ten-year yields rose as much as 11 basis points (bps) on the day to 4.606%, their highest since turmoil after September’s mini-budget, while five-year yields surpassed that peak to reach 4.898%, their highest since July 2008.

Two-year gilt yields, the most sensitive to rate expectations, rose as much as 11 bps too to 5.488%, the highest since June 2008.

All the gilts underperformed against U.S. and German government bonds, with spreads versus Bunds reaching their widest since October at more than 200 bps.