Expectation of UK interest rate rise sends pound soaring to new heights

Bank of England poised to raise benchmark to 4.75 per cent

The squeeze on mortgage holders is set to tighten as the Bank of England gets ready to raise interest rates for the 13th time in a row, experts have said. PA

The pound has surged to its highest level since April last year as the Bank of England prepares to raise interest rates beyond those of the US Federal Reserve and the European Central Bank.

The BoE appears set for its 13th consecutive rate increase, adding a quarter point to reach a 15-year high of 4.75 per cent on June 22.

The bank is grappling with unexpectedly persistent inflation, potentially positioning the UK as a global outlier.

The pound sterling experienced a gain of over 2 per cent over the week, marking the largest weekly increase since early December.

It has also emerged as the best-performing currency among major economies this year.

The Fed recently halted its series of interest rate increases after 15 months, with rates ranging between 5 per cent and 5.25 per cent.

On the other hand, the ECB raised its rates to 3.5 per cent – the highest level since 2001 – and ECB President Christine Lagarde indicated the likelihood of another increase in July.

The absence of specific guidance beyond July from Ms Lagarde has bolstered confidence in the strength of the pound, as the BoE addresses inflation concerns.

Market expectations suggest that the BoE will raise rates to 5.75 per cent by the end of the year.

The pound received an additional boost when Francois Villeroy de Galhau, a member of the ECB's Governing Council, cautioned against prematurely determining borrowing costs' peak.

Mr Villeroy de Galhau emphasised that drawing premature conclusions regarding the terminal rate seemed excessive, alleviating market volatility surrounding the issue.

As a result, the pound reached a high of 0.5 per cent on Friday, surpassing $1.28, and also gained as much as 0.3 per cent against the euro, which is currently trading at about 85p.

During a parliamentary committee session, BoE Governor Andrew Bailey stated that inflation was taking longer than expected to decrease, emphasising the tightness of the labour market.

His comments followed the release of official figures indicating a record-breaking annual increase of 7.2 per cent in basic pay for the three months leading up to April.

Although pay continues to decline when adjusted for inflation, these figures prompted market expectations of further BoE rate increases.

Consequently, two-year government bond yields reached their highest level since 2008.

Economists surveyed by Reuters predict that the BoE will raise interest rates only twice more, culminating in a peak of 5 per cent by August or September.

However, challenges lie ahead for the bank when determining the extent of necessary rate tightening.

Changes in the structure of the UK mortgage market since the last tightening cycle in 2006-2007 have altered the impact of higher interest rates on the economy.

In addition, the nature of Britain's inflation premium over other countries raises questions about whether it represents temporary inflationary pressures or persistent factors.

The potential effects of Brexit and the long-term impacts of Covid-19 on the labour market remain uncertain, leaving the BoE with limited visibility regarding the country's productive capacity.

Market interest rate expectations have returned to the level observed in November, when the BoE indicated that they were overly optimistic.

However, the absence of a new economic forecast or accompanying press conference next week restricts Mr Bailey's ability to communicate with the markets.

Despite the surprising inflation numbers, there is only a slim 15 per cent chance that the BoE will enact a half-point rate increase.

Market participants argue that accelerating policy tightening at this stage would indicate panic or a loss of control for the bank.

Impact on mortgages

According to the Resolution Foundation, a think tank, annual mortgage repayments for the average household in the UK are expected to increase by £2,900 for those remortgaging next year.

The foundation predicts that the ongoing “mortgage crunch” in the country could result in a total annual increase of £15.8 billion in mortgage repayments by 2026.

Simon Pittaway, senior economist at the Resolution Foundation, said: “Market expectations that interest rates are going to rise even higher, and stay higher for longer, are having a major effect on the mortgage market, with deals being pulled and replaced with new higher-rate mortgages.

“Of course, market expectations can be wrong, and rate rises may not turn out to be as bad as feared.

“But with three fifths of Britain’s £15.8 billion mortgage hike still to be passed on to households, rising repayments will deal an ongoing living standards blow to millions of households in the run-in to the general election.”