Markets bet on three interest rate hikes as Iran stance threatens inflation shock for UK
The ongoing rise in oil and gas prices threatens a fresh inflation shock for UK households amid fears of multiple interest rate hikes this year.
While the United States and Iran are locked in a war that has led to the closure of the Strait of Hormuz, the rest of the world is set to pay the price with higher energy costs and increases in transportation, fuel and manufacturing prices.
Rising costs mean inflation figures will rise once again. This came just as data showed inflation returning towards the 2 percent target after three years.
Since one of the most important ways to combat inflation is for central banks to raise interest rates, money market investors are betting on four rate hikes for the rest of 2026, compared to the forecast of two rate cuts for the year until four weeks ago.
“The recent volatility reflects markets starting to meaningfully price in the medium-term damage to Western economies,” Quilter Cheviot investment manager Jonathan Raymond said.
“The UK and Europe appear more vulnerable than the US due to their reliance on imported energy, which is now fueling expectations of weaker consumer spending, slower growth and pressure on corporate earnings.”
It is important to note that investors betting on the markets does not always mean that the central bank, in this case the Bank of England, will follow.
Betting on the market by selling bonds (or bonds) increases returns. Buying them has the opposite effect. At 11:00 GMT, the UK’s two-year bond yield stood at 4.7 percent; This was a full 1 percent higher than the BoE’s actual base rate, which stood at 3.75 percent after last week’s 9-0 vote. In very simple terms, this shows that markets are pricing in an interest rate rise of up to 4.7 percent; This means that when translated into MPC voting terms, they would have to opt for an increase of (almost) fourfold to reach that level.
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However, when external events (such as statements made by political leaders) force a possible change of course, markets can shift very quickly in either direction.
As an example, Donald Trump’s comments about having “productive talks” with Iran saw the same market immediately drop to 4.55 percent, meaning it was back to just three rate hikes in MPC terms.
Market bets are not the same as actual predictions of what will happen six months from now; In part, they are investors who make short-term bets that they can quickly resell over short periods of time.
Aberdeen’s investment director, Matthew Amis, is among those who believe market traders are overdoing it under current conditions and does not believe such sharp rises in interest rates will happen anytime soon.
“We do not think the Bank of England’s communication is as hawkish as market action suggests,” he said. “Governor Andrew Bailey didn’t seem like the man to raise rates three times by September. As for the fiscal package offered by the Labor Administration, only time will tell, but keep in mind that the April price cap somewhat protected consumers until the July price cap was announced in May.”
“All the gilt market needs is for people to start buying. But to do that we need some confidence, and to get that we need de-escalation in the Middle East.”
The challenge for the BoE to raise interest rates comes from a poorly performing economy, rising unemployment and other domestic economic factors, many of which point to the need for rate cuts now. Therefore, before the missiles started to fall, the expectation was that it would drop to 3.5 percent in March or April.
“Central banks are in a difficult position. They cannot allow inflation expectations to rise further, but labor markets are already weakening and the risk of further tightening is amplifying this slowdown. The result is a harsher policy environment than the data would normally warrant, amplifying the volatility we are seeing in equity markets,” Mr Raymond added.
Analysts at Barclays actually want the BoE to refrain from making any changes.
“We expect the Bank Rate to remain at 3.75 percent for the remainder of this year. We assess that maintaining policy for such a restrictive period is sufficient to bring headline CPI inflation back to 2 percent within two years, consistent with the BoE’s mandated target,” Jack Meaning said in a research note on Friday.
Meanwhile, KPMG is actually sticking with a possible outage that could come in late 2026. “The Bank of England is expected to take a cautious approach to monetary policy. KPMG UK forecasts interest rates will be cut only once this year as policymakers worry about persistent inflation pressures,” chief economist Yael Selfin said on Sunday.
“Further rate cuts are likely to be delayed until 2027 as the bank balances rising price risks against a weakening labor market and slow economic growth.”
The BoE will also need to compare what has already happened in Iran with what they predict will happen next.
“Inflation is expected to rise in March as the first impact of higher fuel prices begins to show in official data,” said Thomas Pugh, chief economist at audit and tax firm RSM UK.
“With pump prices rising to around £1.60 per liter by April, we expect inflation to fall only slightly, rather than slowing to 2 per cent as previously forecast. Further down the line, the rise in gas prices will cause Ofgem to raise the energy price cap in July, putting further upward pressure on inflation and pushing inflation back above 3 per cent.”
It is stated that Oxford Economics has an even higher expectation for inflation to reach 4 percent in the second half of 2026 before falling back.
