City bets on rate hikes peaking at below 6% after inflation surprise

CITY traders reacted to today’s faster-than-forecast fall in the rate of inflation with bets that interest rates will now peak under 6%.

They also sold the pound, snapped up UK Government bonds and bought shares in banks and real estate companies as stock markets rallied.

The renewed demand for Government debt sent yields on shorter-dated sovereign bonds, known as gilts, further under 5%, a move that could help ease the extent of upward pressure on mortgage costs.

The yield on two-year gilts fell to 4.88%, having been on the brink of 5% in mid-June.

It helps High Street banks price fixedrate mortgages and was on course today for its biggest daily drop since March, the month the Government held its last Budget. Shorter-dated gilts are most sensitive to the outlook for interest rates.

After the consumer price index eased to 7.9% for June — having been at 8.7% in May and expected to stay above 8% — traders were tearing up their predictions for rate rises. It was the first time during the Bank of England’s run of 13 consecutive hikes that CPI has been lower than forecast.

City bets that the BOE’s battle against inflation would take the UK base rate above 6% were being unwound. The base rate is currently 5%.

Markets were factoring in a peak at 5.9%, having predicted 6.5% earlier this month.

They were also cutting the odds of a smaller, quarter-point rate rise from the BOE at its next policy meeting next month, when a second successive halfpoint hike will also be on the table.

“Is this enough to convince the Bank of England to opt for a quarter-point rate hike in August? We think it probably will — but it’s going to be a close call,” said James Smith, developed markets economist at Dutch bank ING.

He added that policy-makers would probably now watch the rate of inflation in the UK’s dominant services sector as they looked for where to stop hiking. Progress there “should be enough to convince the committee to pause its hiking cycle in November, which would suggest a peak rate of either 5.50% or 5.75%,” he said.

The pound, one of the best performing major currencies recently on the prospect of higher UK rates, fell back. It slid 1.03 cent against the dollar to $1.2930, a drop of 0.8% taking to around its lowest levels of the week.

There were hopes that a shift in the narrative on inflation could prove to be a turning point.

Kitty Ussher, chief economist at the Institute of Directors, said: “The main story today is that inflation is lower than expected, fuelling a narrative that we are through the worst. The Bank of England will hope that this will cause business leaders and others to lower their expectations of future inflation, which could then become self-fulfilling.”

We think the Bank probably will opt for a quarter-point rate hike in August— but it’s going to be a close call James Smith, ING