Advertisement
UK markets closed
  • NIKKEI 225

    39,154.85
    -439.54 (-1.11%)
     
  • HANG SENG

    17,311.05
    -158.31 (-0.91%)
     
  • CRUDE OIL

    77.50
    +0.54 (+0.70%)
     
  • GOLD FUTURES

    2,397.50
    -9.80 (-0.41%)
     
  • DOW

    39,853.87
    -504.22 (-1.25%)
     
  • Bitcoin GBP

    50,680.36
    -428.46 (-0.84%)
     
  • CMC Crypto 200

    1,355.00
    -10.90 (-0.80%)
     
  • NASDAQ Composite

    17,342.41
    -654.94 (-3.64%)
     
  • UK FTSE All Share

    4,468.59
    -10.90 (-0.24%)
     

As interest rates reach peak, the City asks: how far and how fast could they fall?

Interest rates
Interest rates

Andrew Bailey is about to reach the peak of an extraordinarily steep mountain.

The Governor of the Bank of England is expected to raise interest rates for the 15th time in a row on Thursday, taking borrowing costs from the pandemic era low of 0.1pc to a new 15-year high of 5.5pc.

Economists at Goldman Sachs, Citi and many other financial institutions believe this will be the peak. Assuming this is not a false summit and he really is at the top, the next question is one which faces any mountaineer: how to get down again?

Huw Pill, the Bank’s chief economist, has suggested South Africa’s Table Mountain as a model to follow – that is, rates should reach their peak and then stay there in a long, steady plateau.

ADVERTISEMENT

He has warned against a “Matterhorn” pattern of raising rates even higher only to cut again rapidly, a scenario he fears risks causing “unnecessary damage” to the economy.

By contrast Catherine Mann, an external member of the MPC, appears to be leaning more towards the Alpine pinnacle.

“To pause or to hold the policy rate lower for longer risks inflation becoming more deeply embedded, which would then require more tightening in total,” she said last week. “I would rather err on the side of over-tightening.”

Financial markets expect Pill’s view to prevail. Traders think rates will rise to 5.5pc this week and then most likely stay there for at least a year.

The opinion of markets may sound abstract, but this is important for several reasons.

Firstly, the Bank of England bases its forecasts for the economy in part on traders’ predicted path of interest rates. Secondly, it affects banks’ funding costs which in turn dictate borrowing costs for households and businesses.

Markets think rates will eventually fall. Consensus indicates a very slow drop, meaning rates will still be above 4pc even in 2027.

As a result, mortgage borrowers are in the historically unusual position of being offered lower interest rates if they fix for five years than if they fix for two.

David Hollingworth, at brokerage L&C Mortgages, says: “We have seen more borrowers deciding to go for the two year despite those higher interest rates because they are hoping that in a couple of years’ time they will be able to review again and find a more favourable market in place at that point.”

The forward-looking nature of markets means that a rate rise on Thursday will not affect the swap rates on which fixed-rate loans are priced, says Nicholas Mendes at brokerage John Charcol, which are set to keep drifting slowly downwards.

Two-year swap rates, which influence two-year fixed mortgage rates, have been on a gradual decline since early July.

What could impact market borrowing costs, though, are Wednesday’s inflation numbers and the Bank’s commentary around economic pressures.

“That will really set the trajectory for the end of this year, moving into early next year,” Mendes says.

“If inflation does not come down, I would not be surprised if we see another rate increase in 2024 before we see any form of reductions.”

However, many in the City believe the Bank has now done enough to curb price rises.

Christopher Mahon at Columbia Threadneedle says: “We are starting to see the labour market weaken, starting to see house prices coming off a little bit, starting to see input prices in the UK coming down.

“There is a lot of reason to believe we have disinflationary forces building up in the system. We have the ongoing mortgage reset and the austerity that comes after the election.”

As a result rate cuts “might start coming through in eight to 12 months’ time”.

However, the timing of when rates begin to drop is far from certain.

Steve Matthews at Canada Life suspects that fears over persistent inflation will keep the Bank on hold for some time.

“We have taken so much pain to get here, unless there is something that is deeply worrying the Bank of England I think they will want to maintain a degree of control before they start to loosen up the economy again,” he says.

Economists are more dovish than investors, typically anticipating a shorter plateau and quicker rate cuts.

Benjamin Nabarro at Citi predicts rates will start to fall in May of next year, while James Smith at ING thinks it will happen some time between April and June.

“Can we sustain interest rates at 5.5pc indefinitely? Probably not,” Smith says, noting that more and more homeowners will be hit by higher rates as they come to remortgage even if the Bank takes no further action.

As long as wage growth comes back under control, the Bank can announce it is “easing off the brakes a little bit,” he says.

The trouble is, not everyone agrees rates really are at their peak. There is a wing of the City that sides with Mann and believes rates must climb even higher before they can begin to come down.

Melissa Davies at Redburn Atlantic, for instance, thinks Bailey and his colleagues must press on to take rates all the way up to 6pc – and keep them there for some time to make sure price rises and wage rises are brought down.

The Bank for International Settlements, known as the central bank for central banks, also warns against complacency that borrowing costs have peaked.

“The risk that inflation might turn out to be more stubborn than expected is something that we should not rule out,” Claudio Borio, head of BIS’s monetary and economic department, said in its latest quarterly report on Monday.

“Clearly there are still some residual differences between what financial markets are seeing and the communication that has come from central banks.

“Therefore business models [and] trading strategies that were predicated on that assumption [of rates coming down quickly] are particularly vulnerable to current conditions.”

As the world wonders if rates have peaked, Bailey and his colleagues must make sure this is really the top before raising any hopes of a descent from such perilous heights.