BoE and ECB monetary policy changes drive interest rates higher

BoE policy announcement

The BoE had already signalled an increase in base rate from 0.25% to 0.5%, and while this is the first back-to-back rise in rates since 2004, it was fully priced into the market. They also, again as expected, announced that they would not reinvest the proceeds of maturing government bonds as they start their process of quantitative tightening (QT). The two surprises from the meeting were that four of the nine committee members voted for a more aggressive 50 bps hike and that the BoE is now expecting inflation to remain materially above the 2% target this year, peaking at 7.25% in April.

It was this messaging, and the commentary from the minutes, which pushed interest rates up — both government gilt yields (10-year benchmark increased 11 bps to 1.36%) and the swap market with the three-year swap rate now at 1.48%. The chart below shows how much this benchmark borrowing rate has moved since the end of September last year when inflation fears started grabbing headlines. Markets are now expecting base rate to be at 1.5% by the middle of this year. This will be the fastest tightening of monetary policy since the BoE gained independence in 1997. The second chart below shows the forward curve (market’s expectations of future interest rates) and the increase over the past few weeks.

ECB policy announcement

In the EU, swap rates started increasing even before the ECB formally announced their interest rate decision. While rate rises from the ECB are expecting to be further away, the market sentiment now is that these might happen sooner.

The ECB maintained its stance of no change in rates, but there was a substantial change in guidance and language used. ECB president Christine Lagarde stated at their December meeting that a 2022 rate hike was “very unlikely”. This week, Lagarde did not repeat that statement and instead highlighted that given the inflation backdrop the “situation had changed”. The ECB 10 March meeting will be critical as the Council will have a fuller set of economic data on which to base their decisions. On QT, the ECB has continued with the plan to end asset purchases and are comfortable doing this before they start raising interest rates. This QT signalling is increasing market interest rates anyway, and doing the tightening work for the ECB. Before this most recent meeting, it was not expected that EU rates would move above 0% until well into 2023; but as of now, the market expects this to be by the end of this year. The charts below show the three- and five-year swap rates for EURIBOR and the forward curves.

Many of our clients hedge interest rate risk using caps as their product of choice. It is worthwhile noting that the underlying interest rate (as we have discussed above) as well as the volatility of the underlying rate impacts the premium cost of these caps. This week we have seen large movements in both, so if you have indications from your banking counterparties on premiums/rates be aware of how much they will have moved up. Please connect with your Chatham relationship contact if you would like to discuss further.