A pedestrian walks past the Bank of England in London. Markets moved to price in the likelihood of negative interest rates after the central bank said in September it was exploring the practicalities of such a step
Markets moved to price in the likelihood of negative BoE interest rates after the central bank said in September it was exploring the practicalities of such a step © REUTERS

Investors have backed off from bets on sub-zero UK interest rates after a series of vaccine breakthroughs fuelled hopes of a sharp economic recovery next year.

The Bank of England’s main interest rate is now expected to trough at roughly zero per cent in late 2022, according to derivative markets linked to expectations for the path of the bank rate.

Traders had been positioning for a dip into negative territory over the next few years as the BoE faced pressure to cushion the economy from the after-effects of the pandemic.

“The support we had for negative rates seems to have gone,” said Theo Chapsalis, head of UK rates strategy at NatWest Markets. “Right now, the big investors are thinking about vaccines. There’s a focus on the upside rather than downside risks.”

The UK on Wednesday became the first western country to approve a coronavirus vaccine, saying the jab developed by Pfizer and BioNTech could be given to the most vulnerable people as early as next week.

Line chart of overnight index swap curve (%) showing investors have backed off bets for negative UK interest rates

The shift in pricing has accompanied a broader sell-off in global high-grade bond markets, with investors anticipating an economic rebound in 2021 as vaccinations allow economies to reopen, potentially accompanied by higher inflation.

UK government borrowing costs have climbed, with the 10-year yield trading at 0.34 per cent, up from 0.17 per cent in October. The rise reflects a fading of the extreme pessimism that gripped bond markets in recent months, according to Mike Riddell, a portfolio manager at Allianz Global Investors.

“Everyone is now so bulled up on the outlook for the next 12 months. That’s very different from what you were hearing a couple of months ago,” he said.

Markets moved to price in the likelihood of negative BoE interest rates after the central bank said in September that it was exploring the practicalities of such a step. Since then, governor Andrew Bailey has led a parade of policymakers seeking to play down that sub-zero rates are imminent, while at the same time insisting that the controversial policy remains in the BoE’s “tool box” should the need for it arise.

In November, the BoE announced an additional £150bn of bond purchases, underlining that quantitative easing remains its preferred policy for stimulating the economy in the near term.

Line chart of 10-year gilt yield (%) showing UK government bond yields have risen from their 2020 lows

Despite the recent changes in markets, the BoE may still be forced to take the plunge, particularly if the UK leaves the EU in January with no trade deal, some analysts have said. The current average market expectations of a cut down to zero — from the current level of 0.1 per cent — but not below are likely to reflect bets on negative rates from a significant minority of investors that rates will go negative.

Michel Barnier, the EU’s chief Brexit negotiator, has warned that the next 36 hours of trade talks with the UK will be critical in determining whether a deal can still be struck. If the two sides fail to seal a trade agreement then the pressure for negative interest rates is likely to return, according to Mr Chapsalis.

“We have seen this movie before of everyone being optimistic in the UK at the end of the year, and then reality disappoints,” he said. 


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