City Economists Bet Against Markets on Bank of England Rates

Financial markets are pricing at least four Bank of England rate hikes over the next year, lifting the bank rate from 3.75% today to 4.75% by the end of July — and City economists think that pricing is wrong.

Market-implied expectations, drawn from instruments such as swaps, also point to a possible 5% by December 2027. That would mean five rises in total. A string of City experts argue such a sharp tightening cycle is unlikely, citing little evidence that rising energy costs are pushing up other prices sharply.

What do the sceptics actually say?

James Smith, a developed markets economist at ING, put the case bluntly at a City briefing last week: "If you look at the swaps market, and you look at what's priced in for the Bank of England, you've got four rate hikes and then no cuts ever. And I think you'd be hard-pressed to find anybody that really agrees with that."

Smith expects the opposite trajectory. "By next spring, I think they [the Bank] could be sounding the all clear, and by the end of next year they could be cutting rates again," he said. That is a direct contradiction of market pricing, which embeds no cuts at all.

Sanjay Raja, chief UK economist at Deutsche Bank, shares the doubt. "I do not believe that any mainstream forecaster thinks the Bank of England will hike to 5% by the end of next year with the information set we have today," Raja said. "It's not to say it won't happen. But based on current projections, it seems less likely."

Raja's arithmetic cuts the market signal roughly in half. He calculates that much of the forecast rise is actually "baked-in risk premia" — the extra return investors demand to compensate for uncertainty. Strip that out, he says, and only about 50 basis points, or half a percentage point, of genuine hikes remain pencilled in. Deutsche Bank's base case: the bank rate reaches 4.25% by next February and stays there through the end of 2027.

Why is market pricing so high?

The economists point to oil. Market-implied rate expectations have tracked oil prices closely since the Iran war began. The higher oil has climbed, the more hikes traders have priced in.

This creates a trap for anyone betting against the market. An investor could be right that rates will not rise as far as priced, yet still suffer mark-to-market losses and margin calls if oil keeps climbing in the meantime.

"It can get pretty painful, so a lot of traders are quite reluctant to take this risk until there's greater certainty about energy supply and the extent of inflation this winter," Smith said. He noted many traders were burnt at the start of the current Middle East crisis, when most were positioned for further rate cuts this year. The gap between market pricing and economist forecasts may say more about hedging costs than about genuine rate expectations.

What are the banks forecasting?

Goldman Sachs said last month that its probability-weighted forecast path for the bank rate remains "notably below market pricing", though it expects a rise to 4% next month.

Morgan Stanley's base case covers hikes in November and February only, with rates on hold thereafter. Its new research note flags one upside risk: if the Low Pay Commission recommends a larger-than-expected increase in the national living wage, pressure for further hikes could build.

Oxford Economics told clients last week: "We forecast the [Bank's] monetary policy committee will raise interest rates by 25bps [a quarter of a percentage point] at its November and February meetings, taking the bank rate to 4.25%. This is significantly below the peak in money market expectations, which currently point to the bank rate peaking between 4.75% and 5%."

Even inside the Bank, the market's enthusiasm finds little support. Huw Pill, the Bank's hawkish chief economist, told an International Monetary Fund meeting in Bangkok this month that he was sceptical the Bank would need to raise rates four times over the next year.

What happens next?

The Bank of England is widely expected to raise rates to 4% at its next meeting on 5 November, after UK inflation rose further above target in September to 3.5%. The real test of who is right — traders or economists — will come with this winter's energy bills and inflation data.