Rate hike bets ratchet up
As expected, the ECB and Bank of England (BoE) left interest rates unchanged at 2% and 3.75% respectively at yesterday meetings. Both said inflation is set to rise in the near-term on account of higher energy prices and warned of upside risks to the inflation outlook further out (with the BoE stating it is “prepared to act as necessary” to meets its 2% target). The market is now more than fully pricing in a 25bps hike in rates at their next but one meetings in June and about 60bps in total by the end of the year (in the case of the BoE, this is circa 40bps more than was priced in at the close of business on Wednesday). The ratcheting up of rate hike expectations helped lift the euro and sterling, which gained about 1.5 and 2 cents against the dollar respectively, while the pound was also a touch firmer versus the single currency. EURUSD and GBPUSD are trading at around $1.1580 and $1.3430 this morning, with EURGBP at about £0.8620.
The firming of rate hike expectations contributed to a notable increase in bond yields. UK 2-year yields rose by about 30bps – they were up by even more at one stage before BoE Governor Bailey said in a post-meeting interview that he would “caution against reaching any strong conclusions about us raising interest rates”) – while equivalent German yields increased by around 15bps. US 2-year yields, in contrast, were just marginally higher on the day. In equity markets, European and UK stocks underperformed, shedding around 2-2.5%, while the S&P 500 in the US was off less than half a percent. Meanwhile, oil and gas prices have both come off yesterday morning’s highs but remain elevated obviously.
The BoE said UK inflation is likely to rise to around 3.5% in Q3 this year, from 3% in February, given higher energy prices. It said it is “alert to the increased risk of domestic inflationary pressures through second-round effects in wage and price-setting, the risk of which will be greater the longer higher energy prices persist;” while “also assessing the implications for inflation of the weakening in economic activity that is likely to result from higher energy costs.”
The ECB has raised its forecast for Euro area inflation this year to 2.6%, from 1.9% in its December projections, again on account of higher energy prices, but sees it falling back to the 2.0% target in 2027 (versus 1.8% in December). It said “the war in the Middle East has made the outlook significantly more uncertain, creating upside risks for inflation and downside risks for economic growth”, adding that it is “closely monitoring the situation (and will) set monetary policy as appropriate.”
It is a quiet end to the week in terms of economic data with little or nothing of note due for release. Markets will in any case remain focused on developments in the Middle East.