Raising the UK Bank Rate: How Far Can the BoE Go?

We previously wrote an in-depth report on the UK mortgage market and the effect of possible bank rate hikes on house prices. We now broaden the scope to assess what the impact would be not only on consumers but also UK businesses.

BoE Starts Moving Against Terminal Rate

The squeeze on consumers will build the longer mortgage rates stay high. The MPC is clearly very conscious of this, with Governor Bailey and Chief Economist Pill now explicitly pushing back on how high mortgage rates are (in line with our expectation). We have warned of this for a while. Functionally, a pushback on mortgage rates is a pushback on terminal rate (2-5Y swap pricing). Expect to see more of the same ahead.

Bank Rate Feedthrough to Consumer Growing

Since the GFC, the feedthrough from bank rate to mortgage arrears has tended to be around 18 months (Chart 1). As such, we have yet to see the full impact of tightening on households. But that does not mean that it will be mid-2024 before we see the most recent rises’ effect. The scale of the rise should accelerate the feedthrough.

The vast majority of UK mortgages were fixed rate (2-5Y) through ultra-low rates. When rates start to rise, this proportion will fall. Meanwhile, consumer savings rates are already under pressure: from energy prices, inflation, mortgage burden, and rent rises (needed to keep buy-to-let properties profitable). Such a savings rate decline tends to trigger a rise in consumer borrowing (Chart 2). This, along with the shift in mortgages towards floating rates, suggests higher household exposure to rising interest rates and a faster feedthrough from monetary policy into the real economy.

Corporate Interest Burdens Set to Rise Fast

Back in August, the BoE estimated that hiking in line with market expectations (at that time around 2.75% by YE) would not substantially affect capacity for firms to service their debt (approximated by interest coverage ratio (ICR), interest/earnings). They judged a firm with ICR<2.5 to be likely to experience repayment difficulties.

However, since then, the market has priced in substantially more tightening. The market is now pricing year-end bank rate (YE BR) at 3.6% and the 2023 peak at 4.6%. In such an environment, conditions deteriorate rapidly, with the transport and accommodation sectors particularly vulnerable (Chart 3).

According to the BoE calculations, the proportion of firms in difficulty over debt servicing would remain below historic highs in most sectors (c.70% of historic max on average if they hike even to 3.5%). But note two things. (1) The energy situation for firms has improved since then (from the perspective of oil price and government support for business energy). (2) BoE analysis makes no assumption on earnings. We would likely see a considerable deterioration in consumer-facing corporate top lines, which would worsen these ratios. Also notable is that since the BoE’s analysis, UK corporate debt spreads have widened by 40bp.

GDP Impact of BoE Tightening in Line With Market Pricing

The latest monthly GDP reports show economic activity is already shrinking. BoE estimates from November’s MPR suggest even with no further hikes that GDP will trough at the end of next year, c.2% down from Q2 2022’s peak. If the BoE hikes in line with market pricing, it would take another 1pp from this, and push the trough out to mid-2024.

However, the flat interest rate dynamic suggests an unemployment rate of only 1pp above current tights by the end of 2023. This, implicitly, would keep the consumer supported at least by rises in nominal wages.

The reality may be significantly different. The inactivity rate remains the driver of labour market tightness, and even a return to levels seen earlier this year would fully account for a 1pp rise in unemployment (Chart 4). A decline in employment would add further to this (Chart 5).

BoE Will Need to Continue to Push Back on Market Pricing

From the BoE’s perspective, the tightening in mortgage rates and corporate debt is far more to do with pricing on the curve (and the levels of swaps) than the current bank rate. Unless the BoE thinks the UK economy can take the rates being priced now (which appears unlikely given recent rhetoric), further pushbacks on rates priced seems likely.

Various MPC speakers have mentioned the surprising (and, in their view, unjustified) rise in mortgage rates given swap markets have retraced some of the post-‘fiscal event’ move. However, it is not the spread of mortgage rates over swaps that looks particularly odd, but the level of swaps (Chart 6). In short, if the BoE wishes to reduce pressure on consumers via mortgage rates, it will need to suppress market pricing in swaps.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)