Pound's Rate Hike Support Dented by Bank of England Intervention

Still of Andrew Bailey. File image. Source: FT.com.

The British pound's rate hike support was undermined by Bank of England Governor Andrew Bailey's most recent intervention.

Bailey made it clear that the market was out of line in expecting as many as three interest rate rises in the coming months in response to the Middle East war.

The Bank of England governor acknowledged the war will raise inflation, but he's clearly concerned that expectations have run ahead of the reality that is the Bank's own thinking on the matter.

This amounts to an intervention by the Governor to cool the rise in market-determined interest rates.

He said in an interview midweek that market participants were "getting ahead of themselves" by aggressively pricing in rate hikes. These market expectations are incredibly important as they drive real movements in forward-looking money markets, influencing mortgage and savings rates, and the pound.

That forward-looking pricing showed investors saw as many as three rate hikes in 2026 at one point in late March, whereas the expectation at the start of the month was for two cuts.

Above: Market expectations for the outlook for interest rates have risen sharply.

It's a hefty shift that led mortgage providers to jack up interest rates on their offers. It also helped the pound rebound against a number of peer currencies. Those gains are now at risk; those with euro or dollar payments pending should see how current specialist rates compare to their bank while the rebound still has value.

Bailey's intervention could help put a lid on those recent trends; however, a look at near-term bond yields - an important signal for expectations for Bank Rate - shows the pullback in expectations has been limited.

The intervention nevertheless signals there are limits as to how much further rate expectations can rise. Bailey said the Iran war was "intensely frustrating" as it disrupted the previous disinflation process.

"The market is now pricing in two more BoE rate hikes this year instead of more than three at the peak. But based on Bailey's statements, we still anticipate a correction and expect interest rates to remain unchanged this year," says Michael Pfister, a strategist at Commerzbank.

If the view is correct, a key prop for sterling falls away; those with upcoming payments may want to consider securing a rate now rather than waiting for a recovery that policy may not support.

Bailey explained the Bank wouldn't need to raise rates aggressively because there was an "absence of pricing power" amongst firms, as businesses were telling him that they couldn't drive an inflationary spiral by raising prices, as they did at the beginning of this decade.

Importantly, Bailey said a "softening labour market" would also help keep a lid on inflation as it pointed to deteriorating demand dynamics in the economy.

The previous inflation episode was driven by cash-flush households - which had saved during the pandemic - using their savings to spend during a supply shock. The jobs market was also healthy and people could move jobs and command higher wages.

Those conditions are absent this time around and means any inflationary impact from the Iran conflict might not be so enduring and damaging. It implies the Bank of England has less work to do.

For the pound, the implications are two-fold: higher interest rate expectations are traditionally supportive, and Bailey's comments are therefore a headwind. It could explain why GBP/EUR has fallen over recent sessions.

However, it also means the economy won't take another hit from higher interest rates, which would be supportive of the domestic currency over the medium-term.

Economists at Bank of America say the Bank of England will still deliver hikes to meet the incoming inflationary wave, and assume two hikes in June and July 2026.

However, they caution that there's a risk of "one and done". This will be followed by three 25bp cuts from 2Q27 in April, July and November, with risks of four.