Markets eye up interest rate hike in 2018

With all eyes on sterling, one somewhat overlooked development over the past month has been the increase in markets’ expectations for official interest rates. Indeed, on the basis of overnight indexed swap rates (OIS), the MPC is now expected to reverse its post-EU referendum cut in Q2 next year, some seven months or so earlier than was expected around the turn of this year. This probably primarily reflects the strength of the economy, rather than fears about inflation. After all, market based measures of inflation expectations have not risen much over the past month. By contrast, the economic data has continued to be better than expected, with GDP growth maintaining its solid quarterly pace of 0.6% in Q4. This is around its trend-level – a condition for considering raising interest rates according to the Bank of England Governor Mark Carney. Admittedly, there is a lot of uncertainty about the economic outlook and the MPC is likely to tread extremely carefully. But we think markets’ optimism is broadly justified and have pencilled in a hike in Bank Rate in Q4 2018.