Borrowing costs surge as market bets on future Bank of England rate hikes

The government’s short-term borrowing costs climbed to their highest level in more than a year on Wednesday, after the Bank of England announced a unanimous decision to hold its central interest rate.

Traders aggressively pared back bets of future rate cuts on the news that the ongoing conflict in the Middle East led all nine of the rate-setting Monetary Policy Committee to vote to keep interest rates at 3.75 per cent.

The yield on the government’s two-year gilts climbed by more than 20 basis points – or a fifth of a percentage point – to 4.3 per cent immediately after the vote was announced, in a sign investors believe interest rates are likely to remain elevated in the near term.

Several MPC members floated the prospect of an interest rate rise should the situation in the Middle East evolve into a protracted war. In the minutes published alongside the decision, six of the nine-strong committee of economists raised concerns about the long-term inflationary effects of the regional conflict, which has caused oil and natural gas prices to climb to years-long highs.

Bank of England Governor Andrew Bailey said: “I will be monitoring developments extremely closely and stand ready to act as necessary to ensure that inflation remains on track to meet the two per cent target in the medium term.”

Bank of England’s hold sparks rate hike speculation

Bailey’s remarks stand in sharp relief to the Bank’s projections before the conflict broke out. Consecutive Monetary Policy Committee meetings had signalled traders could expect a steady cadence of interest rate cuts throughout this year, with the so-called ‘neutral rate’ – where policy is neither restrictive nor expansionary – expected to be around three per cent.

“If anyone was in doubt as to how the BoE would respond to the current situation, then today is clear,” said Chris Beauchamp, chief market analyst, IG. “A dramatic shift has taken place, and hikes are back on the table as the Bank scrambles to respond to the likelihood of another inflation surge. This was all unthinkable just weeks ago, but is a sign of how the war with Iran has upended everyone’s forecasts.”

The price of short-term bonds – over securities like 10- and 30-year bonds that are issued on a longer time horizon – generally track interest rates and inflation closely. They had been rising through much of the start of the year, as a succession of soft economic data reading led many traders to bet on a faster pace of interest rate rises.

But the onset of the war and its effect on energy prices sent the yield on two-year bonds – which moves inversely to the gilt’s price – to its highest level in 2025.

The sharp market movements will come as a headache to the Treasury, which has been changing the make up of its bond issuance to be more geared towards shorter-term borrowing.

Neil Wilson, Saxo Markets’ UK strategist, said the jump in borrowing costs suggested the Bank of England was now on course to raise interest rates twice this year – an assessment he branded as “way too hawkish”.

 “If the Bank has to hike twice this year it will be because energy prices have materially spiked inflation, the economy will be in freefall already and tightening would just make it much worse,” he added.