UK: No March Madness from the MPC

These days the markets are looking for any sign that developed market central banks will start to “normalise rates”. Since the Bank of England does not release a statement with its interest rate decisions, today’s MPC minutes were the main event. The minutes didn’t throw up any surprises. The Committee voted 6-3 to keep rates on hold. With Andrew Sentance, Martin Weale and Spencer Dale all voting to hike rates, with the other six members including Bank Governor Mervyn King voted for interest rates to remain on hold. The minutes suggest that the Committee is in wait-and-see mode, and some members questioned whether the weakness in growth at the end of 2010 would prove temporary. They also saw “merit in waiting” to see the impact of high oil prices on inflation.

The minutes reiterated that there still remains a large divergence of opinion in the committee about the future trajectory of interest rates. However, the fact the hawks could not persuade another member to join them and call for a rate hike suggests that rates will remain on hold until late summer and reduces the chance of a rate hike in May. Yields on Short-Sterling interest rate futures have moderated since the minutes were released and this has weighed on sterling, which is hovering around the 1.6300 level.

Ahead today the UK Budget will be presented to Parliament by Chancellor George Osborne at 1230GMT. The Chancellor is promising a “growth” Budget after last year’s focus on austerity, but in reality we expect the Budget to remain stable and to contain few, if any surprises. There may be some good news in that borrowing for this year may be lower and the Chancellor may decide to scrap the planned 1p per litre rise in fuel duty to try and ease the burden on households, but measures including the rise in National Insurance contributions for employers and employees from April means that households will continue to be squeezed.

Sweeteners will be few and far between and will need to be fiscally neutral. The rise in the tax threshold is pretty much cancelled out by lowering the level where the higher 40 per cent rate of tax kicks in to GBP35, 000 from GBP37, 400. Incentives for first time home buyers are certainly positive since the number of first time buyers dropped to a record low last year, but they are unlikely to boost the housing market in the short to medium term.

We expect the Office for Budget Responsibility to reduce their growth forecasts for this year to 1.8 per cent, down from 2 per after the weakness in growth at the end of 2010. However, there is a risk that even a 1.8 per cent expansion is too optimistic. Signs of a slowdown in the services sector, a weak housing market and the fact that most of Osborne’s spending cuts don’t come into force until this fiscal year leaves the UK economy extremely vulnerable.

If Osborne sticks to his guns and maintains his ambitious targets including virtually eliminating the deficit in this parliament and significantly reducing public sector borrowing then the markets will no doubt be cheered. Credit Default Swap rates have moderated significantly since the last Budget, Osborne’s first, in June last year, the reward for Osborne’s tough fiscal consolidation plan. So we could see a further boost to Gilts (yields lower) in the aftermath of Osborne’s presentation. This may weigh on sterling.

Sterling has been under pressure this morning as the MPC minutes reduced market expectations for a near-term rate hike from the Bank of England. Osborne’s reiteration that he will continue to push forward with his fiscal consolidation programme will only add to the fears about UK growth going forward, which could further erode support for the pound. EURGBP is also getting a boost and is above 0.8700 in mid-morning.

Elsewhere, risk sentiment is generally lower. Fears of radiation contamination in the Japanese food chain spooked markets and Japanese stocks suffered. The Nikkei closed down 1.6 per cent. However, the strong rebound in stocks this week was probably due a pullback, so we expect markets to be fairly volatile going forward.

Oil is also moderating; however we aren’t seeing a rebound in the dollar. The dollar bears are out there and are looking for blood. This could push the dollar index down to the 71.00 level last reached in 2008. If we breach 75.00 this would make a leg lower more likely. However, the closer we get to the 2008 lows, the larger the chance of a rebound. In 2008 the dollar rose by 25 per cent after reaching 71.80 on 31 March.

Also watch out for Portugal. There is a vote on an austerity reform package at 1500 GMT, and if the government loses the Prime Minister has pledged to step down. Peripheral bond yields are higher and Irish 10-year bond yields spiked to 10 per cent – Greece territory- for the first time this morning. The sovereign debt crisis is far from over and now there is political risk. So far this is being played out in the credit markets and the euro remains resilient. However, it is vulnerable to a near-term decline especially if the EU summit gets side-tracked by political events in Portugal and doesn’t come up with a solid agreement on the ESM long-term rescue fund.

EURUSD has remained supported at 1.4200 for now after ECB member Bini-Smaghi said that keeping rates low would be “very expansionist”. The yield effect continues to drive euro strength and peripheral concerns are getting the brush off from FX investors. The euro is also benefiting from dollar and pound weakness today and is in the running for being the strongest performer out of the majors.

Source: Forex.com

23.03.2011