BOE Policy U-Turn Is Showing Up in Market Wagers Once Again

(Bloomberg) -- Traders are betting the Bank of England will rapidly raise borrowing costs before reversing course almost as quickly. Again.

With inflation looking increasingly sticky, the BOE is expected to raise its key interest rate by 115 basis points over the next 18 months, according to money market pricing. Policy makers are likely to then be forced to unwind about a third of that tightening over the following three years, bringing the key rate to less than 1%.

But earlier this month, many traders positioned for a looming policy u-turn were left licking their wounds after the BOE stunned markets by holding rates steady. And Governor Andrew Bailey warned in the press conference that followed the decision that the pace of tightening traders are anticipating is too aggressive.

“It’s like they never learn,” said Antoine Bouvet, senior rates strategist at ING Groep NV. “It may very well turn out that these hike expectations are exaggerated -- I think they are -- but it is very hard to fight against that trend.”

The latest pricing underscores the pitfalls for traders navigating a world marred by accelerating inflation when tighter policy still poses a risk to growth. From the U.S. to Europe, rate markets were whipsawed this month as central banks pushed back against expectations a rapid increase in borrowing costs, driving real yields to record lows.

Data on Wednesday will show consumer inflation accelerated to a decade-high of 3.8% in October, according to the median estimate in a Bloomberg survey. A market gauge of expected inflation over the next 10 years is now trading around 4%, double the BOE’s mandate. 

Despite the darkening outlook, Mike Riddell, a portfolio manager at Allianz Global Investors, said he doesn’t expect the BOE’s benchmark borrowing rate to peak above 1%, a level that would still be below levels seen before the financial crisis.

He argues that it makes sense for terminal rates for most global central banks in this cycle to be lower than previous ones, given higher debt loads mean economies are more sensitive to changes in interest rates.

“I have more sympathy with the BOE than most,” he said. “I doubt that the BOE is overly concerned by what 10-year nominal rates are, or indeed what 10-year market-implied inflation rates are.” 

The yield on U.K. 10-year gilts jumped by the most in a month this week to 0.91%, trimming a 40-basis-point plunge from a two-year high seen in October.

Not everyone is convinced a shallow hiking cycle will manifest. Mizuho International Plc sees the BOE raising the key rate to 1.5% in this cycle, compared with 1.25% to 1.5% for the U.S. Federal Reserve and 0% for the European Central Bank. 

That’s in part due to the inflationary shock of Brexit, which has created a shortage of labor and exacerbated the supply bottlenecks plaguing the global economy as it reopens.

Further muddying the picture for investors is that central bankers themselves appear at a bit of a loss over the outlook. While they’re watching for signs of tightness in the labor market that could lead to a wage-price spiral if left unchecked, the mantra has been that the latest spike is transitory.

“Just like us, they also don’t know what is going to happen on inflation,” said Rohan Khanna, rates strategist at UBS Group AG, adding that the next few months are going to be crucial in determining whether inflation is topping out. “If we start to see inflation rollover after these peaks, there is a lot of risk premium that will come off.” 

Next Week

• European bond issuance will drop to about 15 billion euros ($17 billion) next week from 18.6 billion euros this week with auctions in Germany, Finland, Slovakia, France and Spain, according to Commerzbank AG
• A slew of European Central Bank officials will speak, including Lagarde, Weidmann and Panetta as well as Bank of England peers including Haskel and Pill.

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