Investors worry over potential BoE rates ‘mistake’
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Investor concern is rising that the Bank of England is moving too swiftly to tighten monetary policy as it gears up to become one of the first central banks to raise interest rates following the coronavirus crisis.
Markets have responded to recent hawkish signals from the BoE by pricing in a series of interest rate rises over the next year, sparking a vigorous sell-off in short-dated government debt. But a lack of reaction in long-dated bonds or the pound betray an anxiety among investors that Threadneedle Street, in its haste to respond to a spike in inflation, may be in danger of committing a “policy mistake”, forcing it to reverse rate hikes.
After governor Andrew Bailey said on Sunday that the BoE “will have to act” to combat rising prices, markets brought forward the expected timing of the first interest rate rise to next month. Another rise to 0.5 per cent is now almost priced in for the December BoE meeting, followed by a further flurry which would take interest rates to 1.25 per cent by the end of next year, the highest level since the 2008-9 financial crisis.
But longer-term gauges of interest rate expectations, such as the three-year three-year forwards — the market’s best guess at where rates will be for three years, starting in three years’ time — have fallen below shorter-dated forwards for the first time since 2008. That means the market is effectively betting on a series of hikes followed by cuts as the economy slows rapidly and the BoE is forced to provide fresh stimulus.
“Is the BoE about to make a policy mistake? Markets sure seem to think so,” said Mike Riddell, a senior portfolio manager at Allianz Global Investors. “There is a lot of history that suggests bad things happen soon after yield curves start to invert, and that’s what is now priced at the front end of the UK rates curve.”
Investors’ concern stems from the perception that there is little that higher interest rates can do to tackle the main drivers of the current surge in inflation, rising energy costs and supply chain turmoil, echoing an argument made by Bailey himself. Instead, by focusing on the need to keep a lid on inflation expectations, the BoE governor risks exacerbating an approaching economic slowdown.
“Not only do we have the growth hit coming from energy, but also an increasingly wobbly China and super aggressive policy tightening makes financial conditions a heck of a lot tighter,” Riddell said.
A rapid series of rate increases would put the BoE out of step with other big central banks, even in a world where inflation is proving stubbornly high across developed economies. The US Federal Reserve is not expected to raise rates until autumn 2022, while the European Central Bank and the Bank of Japan are likely to keep rates on hold for longer.
Despite recent hawkish moves, sterling has derived little benefit from the prospect of higher UK rates, falling against the euro and the dollar on Monday. Against the single currency the pound remains close to last week’s 19-month high, but analysts say this strength is not close to fully reflecting the bond yield differentials that have opened up between the UK and the eurozone.
The inversion of parts of the UK yield curve — implying increases could be followed by cuts — go a long way to explaining the “limited ability of [currency markets] to follow-through on the huge central bank repricing taking place”, said George Saravelos, Deutsche Bank’s global head of FX research.
“It’s supportive for your currency if you are raising rates because the economy is steaming ahead,” said Mark Dowding, chief investment officer at BlueBay Asset Management. “But if you jack up rates in a slowing economy that’s a different story.”
Some fund managers argue that market expectations for higher rates are now running far ahead of what the BoE is likely to be able to deliver before an increasingly gloomy growth picture holds it back.
“The BoE have talked themselves into the ‘Nightmare before Christmas’ scenario,” said Jim Leaviss, chief investment officer for public fixed income at M&G Investments. “But when you factor in the squeeze on households coming from higher gas prices, global supply chain issues and mortgage costs, there’s going to be a pullback in growth. It’s hard to see them managing more than a rise or two.”
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