Bank Base Rate and the gap between narrative and reality

Over the past month, it has become increasingly difficult to ignore the seemingly growing strength of a, mainly mainstream, media narrative suggesting Bank Base Rate (BBR) rises are just around the corner, with markets pricing in multiple increases over the course of this year and commentary quickly following suit on why this is likely to happen.

However, when you step back from that noise and focus on what is actually being said by the Bank of England itself, the picture looks rather different, not least because the governor, Andrew Bailey, has been clear in suggesting markets are getting ahead of themselves when it comes to expectations of future rate hikes.

That alone should give pause for thought, because while markets will always form their own view, it is unusual to see such a clear divergence between central bank messaging and market pricing, particularly when the central bank is actively attempting to dampen expectations rather than reinforce them.

A different view from economists

It is not just the Bank pushing back against the current narrative, because a number of economists are also pointing towards a more stable outlook for BBR, with forecasts suggesting rates could remain on hold for an extended period, even in the face of rising inflation.

That may appear counterintuitive at first glance, especially when inflation is expected to move higher in the short term, but it reflects a broader understanding of the economic backdrop we are currently dealing with, which is far from straightforward.

In other words, the assumption higher inflation automatically leads to higher interest rates is not one that necessarily holds in the current environment, and relying on that link alone risks missing the bigger picture.

Understanding what is actually being priced

One of the more important, and often overlooked, elements of this debate is the distinction between what markets appear to be pricing and what they are actually reacting to, because while it is easy to interpret higher swaps and increased short-term funding costs as a signal of future BBR rises, that is not necessarily the case.

At present, there is significant pressure in short-dated money markets, with a sharp increase in demand for short-term funding and a limited supply of available liquidity, which has pushed the cost of that funding materially higher over shorter timeframes.

The technical impact of this is that three and six-month money is trading at a premium to base rate, which in turn feeds into the pricing of two-year funding and therefore mortgage products, creating a steeper short-term curve.

However, this is a reflection of funding conditions rather than a clear indication that markets are convinced BBR rises are coming, and conflating the two risks drawing the wrong conclusion from what are essentially technical movements.

Why the economic backdrop matters

When considering where BBR might go next, it is also important to place the current situation within its wider economic context, particularly given we are now entering a period that can reasonably be described as stagflation, where growth is weak and inflation is rising.

In such an environment, the traditional policy response of raising interest rates becomes far less straightforward, because increasing borrowing costs risks further suppressing already limited economic activity without necessarily addressing the underlying drivers of inflation, many of which are global and supply-driven. As the Bank of England said itself, it can’t conjure up more energy.

Central banks are well aware of this dynamic, and it is difficult to see why they would choose to exacerbate those pressures unless there was a clear and sustained risk of inflation becoming embedded, which at present does not appear to be the prevailing view.

The role of sentiment and short-term thinking

That is not to say markets are behaving irrationally, but there is a sense that short-term sentiment and positioning are playing a significant role in driving recent movements, particularly in an environment where uncertainty is high and liquidity conditions are tight.

We have seen similar episodes before, where pricing has moved quickly in response to headlines, national political and/or geopolitical developments, or shifts in expectations, only for that movement to reverse once a more measured view takes hold. The ‘Mini Budget’ being the most obvious recent example.

There is also a question as to how much of the current narrative is being shaped by a desire to anticipate the next move rather than reflect the most likely outcome, which can sometimes lead to an overextension in pricing that does not fully align with underlying fundamentals.

Keeping a sense of perspective

For those operating within the mortgage market, the distinction between technical pricing movements and actual BBR expectations is more than academic, because it directly impacts how products are priced, how lenders behave, and ultimately how clients are advised.

What the past few weeks have shown is that pricing can move quickly and, at times, sharply, but that does not necessarily mean the direction of travel for BBR has fundamentally changed.

With the Bank of England urging caution, economists pointing towards stability, and the economic backdrop limiting the scope for aggressive policy action, there is a strong case for taking a more measured view of where rates are likely to go next.

That does not mean markets are wrong, but it does suggest the current narrative may be running ahead of the reality, and in a market such as this, that is a distinction worth paying close attention to.