BoE holds while striking an unexpectedly hawkish tone

Highlights: The Bank of England kept rates unchanged at 3.75 per cent, reflecting rising inflation risks driven by the US/Israel - Iran conflict, which has pushed up global energy prices and is already feeding into higher household bills. While the Bank remains focused on returning inflation to its 2 per cent target, the conflict has disrupted both its outlook and broader global growth expectations, particularly given risks around oil supply through the Strait of Hormuz. We see this as a temporary setback to the disinflation trend, with potential downside risks to growth and employment, and expect the BoE to resume rate cuts later this year, and taking the rate towards 3.0 per cent by mid-2027. In portfolios, we maintain modest overweights in both UK conventional and index-linked gilts, while UK’s defensive and commodity exposure offers some resilience, keeping us neutral on equities.

• The Bank of England held its main interest rate at 3.75 per cent due to renewed concerns about inflation following the ongoing conflict in the Middle East. The decision was unanimous, with all nine members of the MPC voting to keep borrowing costs on hold. Governor Bailey said “the Bank’s job is to make sure inflation gets back to its 2 per cent target, and that the war has pushed up global energy prices, which will feed into higher household energy bills.” Market reaction was sharp after the BoE decision as 2-yr gilt yield moved by +30bps on intraday levels
• However, the conflict in Iran has significantly disrupted both the Bank’s outlook and broader global economic forecasts, particularly through its impact on oil prices. The longer the war continues, and especially if it continues to disrupt trade through the Strait of Hormuz, the greater the economic strain is likely to be. This is a critical risk, given that roughly one-fifth of the world’s crude oil passes through this route. The most immediate impact has been felt in energy markets. Oil and gas prices have moved sharply higher since the conflict began, with another surge seen earlier today. As Bailey pointed out, the effects are already visible in rising fuel prices, and if these pressures persist, they are likely to translate into higher household energy bills later in the year
• We think that the disinflation process might be temporarily disrupted and offset by a negative impact on growth and employment. Hence, we expect the BoE to cut Bank Rate to 3.00 per cent just a little later with a pause for now, followed by cuts in November 2026, February 2027 and April 2027
• Portfolio implications: We see rising inflation expectations for the UK, which suffers from sticky core inflation, which is further compounded by the oil price shock. We think breakeven inflation could rise further so we upgrade index linked gilts to mild overweight, in line with our existing view on conventional gilts. The UK’s defensive tilt and commodity exposure provide a potential hedge in volatile periods, though it is not a domestic growth story and hence we remain neutral on UK equities