U.K. Rates Markets Start Mapping Path to Higher Borrowing Costs

(Bloomberg) -- Investors should start preparing for higher U.K. borrowing costs, even if they take a while to materialize.

That’s the view of strategists at UBS Group AG and NatWest Markets, who recommended positions that would benefit from an increase in interest rates in a year or two.

While the Bank of England has signaled it will continue to support the economy with record-low interest rates and 150 billion pounds ($209 billion) of bond buying by year-end, the success of the U.K.’s vaccination drive has super-charged the recovery and plans for a full reopening in June look to be on course.

A market measure of price increases climbed to a decade-high last month. Any further rise in inflation expectations could prompt the Monetary Policy Committee to take stronger steps to control rising prices once the dust has settled, wrote John Wraith, head of U.K. and European rates at UBS.

“In due course, the MPC will raise rates materially faster than is currently priced in, should inflation dynamics require them to do so,” said Wraith, adding that a further material rise in rates in one year “could be imminent.”

To capture the move, he recommends paying one-year swaps, starting in two years against the overnight rate or targeting a higher premium on the one-year swap rate between the one- and three-year forward points.

Such swaps exchange fixed-rate payments for floating-rate ones, and are used by investors ranging from pension funds to insurers, as well as companies managing their future liabilities.

Meanwhile, NatWest Markets envisages a similar response by BOE policy makers to higher growth and inflation numbers, and doesn’t rule out a single 40-basis-point rate hike to 0.5% at some point in 2023. U.K. strategist Theo Chapsalis recommends paying two-year overnight rates one-year forward to position for such a move.

The BOE announces its latest policy decision at 12 p.m. on Thursday, with money markets betting the central bank will keep interest rates steady for the remainder of the year before raising them about 45 basis points in two-year’s time.

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