BOE & ECB Interest Rate Expectations Update

Central Bank Watch Overview:

• Ahead of likely recessions in the UK and the Eurozone, the Bank of England and European Central Bank are poised to raise rates to ward off inflation pressures.
• The BOE’s inflation fighting task has been complicated, however, by the apparent need for intervention in UK Gilt markets.
• Retail trader positioning suggests EUR/USD rates have a bearish bias while GBP/USD rates have a mixed bias.

Aggressive Hikes Ahead of Recessions

In this edition of Central Bank Watch, we’ll cover the two major central banks in Europe: the Bank of England and the European Central Bank. The economic situation is deteriorating in both the UK and the Eurozone, thanks in part to the unfolding energy crisis. While recessions appear likely for the regions, both the BOE and the ECB appear poised to raise rates aggressively in the coming months in an attempt to ward off multi-decade highs in inflation pressures – which in turn may make potential recessions more severe.

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BOE Hike Odds Skyrocket

UK stagflation remain elevated, although the recent UK mini-budget might provide enough fiscal support to the UK economy to prevent a significant downturn in growth. Nevertheless, with an energy crisis building, the coming months may prove very difficult for the UK economy.

As the BOE works to curb multi-decade highs in inflation pressures, its fight has been complicated by the fact that markets see the recent UK mini-budget as imperiling the country’s fiscal position, sending UK Gilt yields soaring. In turn, the BOE announced expanded bond buying efforts through the end of this week to prevent further dysfunction in UK bond markets.

Bank of England Interest Rate Expectations (October 11, 2022) (Table 1)

The BOE’s efforts to keep UK Gilt yields capped vis-à-vis QE is seemingly counterintuitive to their efforts to fight UK inflation by raising interest rates. UK overnight index swaps (OIS) are discounting aggressive action moving forward, with a 49% chance of a 125-bps rate hike in November (a 100% chance of a 25-bps hike, a 100% chance of a 50-bps rate hike, a 100% chance of a 75-bps rate hike, and a 100% chance of a 100-bps rate hike). After a likely 100-bps rate hike in November, another 100-bps rate hike is discounted in December.

The BOE’s main rate is expected to peak at 5.770% by June 2023, a sharp increase from two months ago when the main rate was discounted at 4.267% by June 2023.

IG Client Sentiment Index: GBP/USD Rate Forecast (October 11, 2022) (Chart 1)

GBP/USD: Retail trader data shows 55.47% of traders are net-long with the ratio of traders long to short at 1.25 to 1. The number of traders net-long is 1.35% lower than yesterday and 2.97% higher from last week, while the number of traders net-short is 0.41% lower than yesterday and 0.30% higher from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests GBP/USD prices may continue to fall.

Positioning is less net-long than yesterday but more net-long from last week. The combination of current sentiment and recent changes gives us a further mixed GBP/USD trading bias.

ECB Hiking into Recession

ECB policymakers may not be dealing with dysfunctional bond markets to the degree that the BOE is recently, but like the BOE, they are attempting to raise interest rates to curtail multi-decade highs in inflation rates ahead of a recession in the Eurozone.

As recession fears mount, however, the runway that the ECB has to try to raise rates is starting to shrink, leaving policymakers with a stagflation quandary: raise rates to try and lower price pressures at the risk of a more severe economic contraction; or halt rate hikes, running the risk of persistently higher inflation, in order to prevent a sharp recession.

EUROPEAN CENTRAL BANK INTEREST RATE EXPECTATIONS (October 11, 2022) (TABLE 2)

Eurozone OIS are now pricing in an 85% chance of 75-bps rate hike later this month (100% chance of a 25-bps rate hike and a 100% chance of a 50-bps rate hike). At present time, rates markets are expecting a steady pace of hikes thereafter, with a 50-bps rate hike discounted in December and again in February 2023.

€STR, which replaced EONIA, is now priced for at least 225-bps more hikes through September 2023, where the ECB’s main rate will peak at 3.014% (currently 0.75%).

IG Client Sentiment Index: EUR/USD Rate Forecast (October 11, 2022) (Chart 2)

EUR/USD: Retail trader data shows 59.42% of traders are net-long with the ratio of traders long to short at 1.46 to 1. The number of traders net-long is 1.12% higher than yesterday and 17.07% higher from last week, while the number of traders net-short is 5.17% lower than yesterday and 4.14% lower from last week.

We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests EUR/USD prices may continue to fall.

Traders are further net-long than yesterday and last week, and the combination of current sentiment and recent changes gives us a stronger EUR/USD-bearish contrarian trading bias.

— Written by Christopher Vecchio, CFA, Senior Strategist