BoE Preview: No Rate Hike In May

Key points We expect the Bank of England to keep the base rate unchanged at 0.5% on Thursday. UK rates could fall further as some still see a chance of there being a hike. It is increasingly likely that BoE will be on hold throughout 2011

One had to almost be deaf, dumb and blind in February not to realise it: Rate hikes were imminent. Bank of England governor, Mervyn King, practically informed the markets that he would raise rates soon when he wrote to the Chancellor to explain why inflation was twice as high as the Bank's target. The governor noted that if the MPC tightened monetary policy at the pace at which the futures markets expected at that time, inflation would probably fall back near to the target on the medium horizon. Several analysts brought their expectations of a first rate hike forward. New MPC hawks emerged. Even more analysts were betting that rate hikes were coming soon. But then data started to deteriorate...

UK output shrank 0.5% in Q4 and advanced around the same in Q1, i.e. the economy has been flat lining since Q3 last year. Underlying growth is absent or at best, weak. Consumer confidence is at levels only seen in the recessions of the early 1990s and late 2000s. Unemployment remains high and disposable income keeps shrinking as households are seeing their spending power eroded at the fastest rate in more than 60 years. We are worried that the stream of weak data will continue for most of 2011.

The MPC has on balance become quite dovish lately, spooked by the recent parade of gloomy data. The governor recently said that high debt levels pose 'massive' economic challenges that would be exacerbated by long-term interest rates and that 'the economic consequences would become more severe if rates were to rise'. This indicates that rates can never rise to previous levels again. Martin Weale, an MPC member who has been voting for rate hikes since January, recently indicated that he may vote for rates to be left on hold in the wake of the latest poor data.

It is the last meeting for über-hawk Andrew Sentance, who has been voting for higher rate hikes since June last year and most recently preferred to double the base rate, fearing that the Bank of England had lost credibility. As he is a colourful character, we will miss him but we will not miss his hawkishness, which could have been costly for the UK economy and perhaps made it even harder to get the recovery back on track. Sentance will be replaced by Ben Broadbent, former Goldman Sachs economist, who probably will start out as 'neutral' in June, voting for unchanged rates like the majority of the committee.

With Martin Weale perhaps pulling his call for higher rates at this meeting and Sentance not present at the June meeting, the voting outcome could go from 6-3 in April, to 7-2 in May and 8-1 in June. Spencer Dale, the Bank's chief economist, who has preferred a rate hike since February, must also be worried about the justification of his stance by now and if he pulls out, the committee could again unanimously opt for easy monetary conditions - just like a year ago.

Thursday's rate decision could have some market impact as some traders perhaps still believe there is a small possibility of a hike. According to the OIS market, there is less than a 10% chance of a hike and all forecasters asked by Bloomberg barring one expect unchanged rates, but we have previously seen volatility after seemingly anticipated outcomes. With a soft Inflation Report coming up next week and with three months to the August report, we think short rates could fall even further and the pound could continue to underperform the euro up to 0.92

Follow up on trade ideas

In our research note from 5 April, The Bank of England's dilemmas, we proposed two strategies for those who believed that the MPC would leave the base rate unchanged at 0.5% throughout 2011.

We proposed to:

1. Sell November OIS @ 110.5bp for a target of 60 and with a stop at 130bp. With November trading at 74bp, this trade has performed well and we recommend keeping it on for now. There may actually be another 20bp in this trade if the number of hawks starts to diminish, which in our view seems likely.

2. Sell Sep 11 short sterling future vs buy Sep 12 @ 112bp, target 90bp, stop at 127bp. This trade met its target yesterday, now trading at 81bp. We doubt that this trade has much further to go as the Sep 11 has already fallen a lot and the BoE most likely will be in a process of normalising rates next year.

We like to buy EUR/GBP on dips up to 0.92. Unfortunately, there haven't been many dips. With the ECB probably set to deliver two more rate hikes this year and one early next year, the rate differential between Euroland and the UK could widen further.