Interest Rate Forecast: UK Inflation Risk and Gilt Yields Drive GBPUSD and EURGBP

This suggests that the BoE policy now depends on the energy prices in May and June. If the energy prices remain high in May and June, the energy inflation will likely transfer to the broader inflation which will likely make it more difficult for the BoE to cut rates.

The market is not expecting further rate cuts this year due to higher energy prices. This has turned the market to more hawkish trajectory. The market expects the BoE to maintain its current rate of 3.75% this year.

Financial markets are more aggressive and have priced in multiple increases. This is a significant gap. It indicates investors are more worried about inflation than economists are about recession.

The BoE is now left with two risks. Rates that remain too low could lead to an increase in inflation and negatively affect credibility. If the rates increase significantly, the economy will decelerate further. This places the upcoming policy meetings as important policy meetings for UK assets.

Gilt Yields Show Why the BoE Cannot Turn Dovish Too Quickly

The gilt market is sending a clear message. The yield on the UK 10-year gilt recently spiked up to 5.18% which is the highest level since 2008. This is much greater than similar yields in the United States and Germany. It reflects a higher risk premium being demanded by investors on UK government debt.

Political uncertainty is a reason. Prime Minister Keir Starmer is under pressure and investors fear that if he does lose his leadership position, fiscal policy would loosen. The Liz Truss shock is still on the radar. Investors have long been reminded of unfunded plans to cut taxes which had a negative impact on gilts and caused the Bank of England to intervene.

But there is more to politics than meets the eye. The UK gilts also have a higher inflation risk, higher volatility and lower structural demand from long-term domestic buyers. In the past, pension funds and insurers bought long-dated gilts to match liabilities. Gilt prices are now more sensitive to shocks due to increased participation by more foreign and short-term investors in the gilt market.

This is important when determining the interest rate prediction. Before the BoE hikes rates, the tightening of financial conditions is caused by high gilt yields. The cost of mortgages, business loans and government interest payments increases. Higher gilt yields may be in prospect if the BoE is seen as too dovish amid an increase in the inflation threat. That’s why the central bank may need to maintain a hawkish stance, although it may not immediately hike rates.

Based on the chart below the US 10-year gilt has broken the triangle pattern at 5% and looks for further upside. The formation of base patterns and then the triangle breakout suggest continued upside.