Britain’s interest rates are spiralling into a national obsession

LONDON – On the same day traders priced in expectations that British interest rates would hit their highest since 1998, Bank of England (BOE) governor Andrew Bailey was explaining inflation to children. 

Sitting down to an interview on CBBC’s Newsround, a TV show aimed at children as young as seven, Mr Bailey was lamenting how families now faced “very difficult choices” because of rising mortgage costs. In London, newspapers put warnings about interest rates and bright red lines pointing skyward on the front page. 

While Britain’s cost-of-living crisis has been brewing for months, this was a week when the fear over interest rates seemed to escalate on its own. There was no political drama to unsettle markets, no big economic surprise – only the sense that

the country is dealing with out-of-control inflation

and interest rates inevitably have to keep increasing.  

And the question still on everyone’s mind: How much higher can interest rates and bond yields go? On London’s trading floors, there is a mix of answers.

Some argue the British economy is bound to weaken so quickly that the BOE will not need to raise rates to 7 per cent to bring inflation down. Others point to resilience in consumer spending as a reason why borrowing costs will continue to rise.     

“We expect the wheels to come off before the BOE delivers the tightening that the market is bracing (itself) for,” said Rabobank rates strategist Richard McGuire. 

While bond yields have surged globally, Britain has seen

some of the sharpest moves

because of its persistent inflation. The BOE has already delivered 13 rate increases since late 2021, yet inflation at 8.7 per cent has beaten estimates four months running and still remains well above the 2 per cent target.

For investors, it was a tough week. The benchmark 10-year rate reached as high as 4.7 per cent. The other instances of yields that high were last October – when the nation was in the grip of then

Prime Minister Liz Truss’ budget chaos

– and the 2008 global financial crisis. The blue-chip FTSE 100 index sank 3.7 per cent, the biggest weekly sell-off since March.

At one point during the week, traders priced in a one-in-three chance of the key rate rising to 6.75 per cent, a level last seen when the Spice Girls and Oasis topped British music charts. That compares with wagers on a 5 per cent peak just a couple of months ago.

“Absolutely, rates could go to 7 per cent if data continues to surprise to the upside,” said Mr Ales Koutny, head of international rates at Vanguard.

“We have seen a very strong shift on BOE rhetoric. Before, it was trying to find a way to not hike rates any more. Once we got to 4 per cent and kept getting better economic data, it felt like the BOE finally decided to do what it takes.”

The housing market shows the strain.

British house prices are falling at their fastest annual pace since 2011, according to a report from mortgage lender Halifax.

And there is a worry that as rate increases work their way through the financial system, other vulnerable parts of the economy will come under pressure.

“The risk of something breaking, and breaking badly, is getting bigger the more that rates go up,” said Mr Mike Riddell, a macro portfolio manager at Allianz Global Investors. 

Among investors, there are divisions over whether United Kingdom bonds are a good opportunity to lock in juicy yields or are on the verge of another sell-off as rate expectations keep climbing. 

In the bullish camp, Mr Riddell said central banks have already tightened rates too much, and gilts are a bargain too cheap to pass up.

Mr Samuel Zief, head of global foreign exchange strategy and markets at J.P. Morgan Private Bank, likes short-dated gilts because they offer high yields and provide a buffer against further shocks.

“We moved bullish gilts a couple of weeks ago, as we think gilt valuations are now looking very interesting,” said Mr Riddell. “They just got more interesting.” 

One reason the UK bond market is so volatile is that liquidity has dried up, said Mr Koutny. He says many investors stepped away from the market after the mini-budget crisis in 2022 and are watching the data for stronger evidence that a pause could be in sight. 

The problem, in the view of some market watchers, is that investors have been burned over and over again trying to predict British interest rates.

Mizuho rates strategist Evelyne Gomez-Liechti says investors will be less willing to own gilts, given the backdrop of uncertainty and volatility. 

Or in the words of Ms Imogen Bachra, head of UK rates strategy at NatWest Markets: “Gilts are a falling knife that no one wants to catch.” BLOOMBERG