Bank of England: 25 or 50 basis points rate hike?

The recent drop in UK rates has mirrored improved sentiment in Europe and the US, where inflation is decelerating, fostering speculations that the Fed and the ECB might be approaching the end of their hiking cycle.

However, even though core inflation for June was revised downward to 6.9% from 7.1%, the UK continues to experience the highest inflation in the G7 economies. At the same time, the labor market remains tight while wages continue to pick up.

The macroeconomic backdrop calls for more tightening. However, financial markets remain wary of pricing a peak rate above 6% as they believe that the BOE might be near to risking a deep mortgage crisis.

The 2-year swap spread remains elevated, showing that 2-year gilt yields can run higher. Therefore, even if, at this meeting, the BOE decides to hike only by 25bps and yields adjust lower mimicking rate moves in the US and Europe, Gilts will remain vulnerable to renewed inflation worries in the fall.

In the meantime, 10-year yields remain rangebound between 4% and 4.6% as economic data remain in focus next week.

Hypothesis 1: The Bank of England hikes rates by 25 basis points

In this case, the market will confirm expectations for the peak rate to be around 5.75%, provoking a further bull steepening of the UK yield curve. Two-year Gilt yields might further drop to find support around 4.68%.

There are several risks linked to such a decision.

First of all, the BOE might risk remaining the last hawk standing. While the ECB and the Fed prepare to end their hiking cycle, the fight against inflation is still ongoing in the UK, calling for the BOE to continue to tighten monetary policies while its peers will not.

Secondly, if the BOE hikes only by 25bps, it opens to the risk that it might need to hike rates by 50bps again in the future, increasing uncertainty surrounding the central bank's forward policy. Therefore, the bond market must price a higher risk premium in Gilts, exposing the yield curve to more volatility.

The only advantage of such a decision is that the BOE will not risk overtightening, especially in light of the BOJ exiting its yield curve control policy. Yet, the normalization of monetary policies in Japan will likely take a long time, while concerns regarding inflation in the UK are ongoing.

Hypothesis 2: The Bank of England hikes rates by 50 basis points

If the MPC wants to remain credible and stick to its data-dependent approach, it will hike rates by another 50bps. This way, it will catch up with the Fed and the ECB without running the risk of continuing to raise rates much further into the future while its counterparts end their hiking cycle.

In that case, markets will increase the chances for the peak rate to be around 6.25%, provoking a bear flattening of the yield curve. Two-year yields will resume their rise to test resistance at 5.5%.

Hypothesis 3: The Bank of England hikes rates by 25 basis points and pre-commits to another rate hike in September

Despite the BOE doesn't like to set forward interest rate guidance and largely remains data dependent, during this meeting, there may be scope to hike by 25bps and pre-commit to another 25bps hike in September. Markets would interpret such a move as a hawkish hike, as the BOE guarantees another rate hike when the Federal Reserve and the ECB are largely expected to pause.

Such a strategy would leave room for a peak rate of around 5.75%-6%. However, the implied message is that the central bank will arrive there by hiking at a pace of 25bps rather than 50bps. That would push the current peak rate expectations slightly higher. Rates will remain underpinned around their trading levels today, tilting up.

The problem with such a strategy is that the BOE cannot use its economic forecasts to back up such a decision. Indeed, an external review by Ben Bernake is beginning as the central bank’s forecasts have been largely unreliable.