BoE Preview: Another GBP50bn QE - and More to Come

Key points

• We expect the BoE will lift the asset purchase target by GBP50bn to GBP325bn and leave the base rate unchanged at 0.50% on Thursday.
• UK data has lately surprised on the upside, but expectations have been low. A technical recession might just be avoided. Data is however very soft, suggesting monetary policy remains too tight and that more alternative stimulus is required.
• As our view is in line with the consensus forecast, we don't expect a large market reaction.
• We recommend receiving the June '12 IMM FRA at 94bp for a 82bp target and with a stop at 100bp.

Cancel the technical recession for now

The latest stream of data suggests the UK might not be in a mild technical recession after all. That fits nicely with our less-pessimistic-than-consensus-stance, and we expect other forecasters to revise their projections higher over the next couple of weeks, in line with ours.

Retail sales in December were good - up 2.6% y/y - and PMI data for the service sector in January were excellent - rising to 56, suggesting strong expansion. So we would not be too pessimistic just yet. Last quarter's 0.2% q/q economic contraction should not be overstated; latest data suggest 0.1-0.2% growth in the current quarter, meaning the recession may never emerge. Challenges remain, but fears may have been exaggerated.

Bank of England is ready with more asset purchases

Does this mean the Bank of England will stop buying Gilts to keep interest rates low and stimulate the economy? No, not at all, in our view. The BoE has just completed the first stage (GBP75bn) of the second round of its quantitative easing programme and more is to come, which has been indicated in various comments and speeches from MPC members. Inflation is coming down rapidly, albeit from a high level, and is likely to undershoot the BoE's 2% target later this year, so the BoE can afford to print more money and spend it on low-yielding Gilts.

Some have argued that the BoE would lift the asset purchase target by another GBP75bn but that will, in our view, only happen if the BoE again chooses to focus on a four-month programme. We find it more likely that the BoE will switch to a GBP50bn three-month schedule, which fits with the Inflation Report months where the decision can be explained in detail. We are, in other words, likely to witness a repetition of May 2009, where the BoE also lifted the target by GBP50bn (and again in August). It is likely to mean that the weekly purchases going forward will be a tad smaller than from October-January, but we doubt it will have an effect on the daily activity. We believe the buying strategy will be left unchanged, i.e. 3-10 years on Mondays, 10-25 years on Tuesdays, 25+ on Wednesdays and Thursday-Friday off. As a GBP50bn increase to a total GBP325bn is the consensus among forecasters, we do not expect to see a big market reaction.

We think the Bank of England will continue to buy Gilts in most of 2012. Specifically, we estimate the total asset purchases will amount to GBP400bn by end-2012. It is difficult to estimate the total programme, but we expect the economy to expand in H2 12 after having been broadly flat for some time.

After dipping below 2% at the beginning of last week, the yield on the 10-year Gilt has risen to 2.16%. The scope for the 10-year rate creeping much higher in H1 is, in our view, limited due to a still relatively bleak economic outlook and the BoE's asset purchases. The downside - probably just below 2% - should also be protected, as the recession fears last month could not drag the yield much lower than 2% and BoE is not likely to accelerate its Gilt buying. So we would position for the 1.95-2.25% range.

Receive June '12 IMM FRA

In our January BoE preview, we pointed out that Sterling Libor rates were close to a stabilisation. Not long after, Libor rates actually peaked and have lately fallen below levels from the beginning of the year. As the BoE has not done anything to improve the liquidity situation in the interbank market, we guess it is a positive side effect of the ECB's 3-year Long-Term Refinancing Operation. With plenty of cash in the system and some Libor contributors dumping rates, we believe the Libor curve has made a U-turn and lower rates are in the pipeline over the coming weeks.

To position for lower short rates in the near term, we recommend receiving the June '12 IMM FRA at 94bp for an 82bp target and with a stop at 100bp. 3-month short sterling has fallen below 1% from 1.16% a month ago but remains above the average of 0.90% from Summer 2011 - a level we might see again if liquidity continues to improve as we think.

Update on September Euribor Libor spread

Our recommendation from last month - buying the September Sterling future against selling the Euribor future at 12bp for a -10bp target and with a stop at 25bp - has not moved much. The September Sterling future has risen but so has the Euribor future. As we think UK short rates will fall further over the coming weeks while the Euro rates may be closer to a bottom, we leave the trade open for now.

Our BoE base rate indicator suggests a lot more QE

The charts below show detailed information on our Base Rate indicator. As can be seen, the indicator is very negative with almost all input factors well below neutral level. Monetary stimulus like 2009 is not required, but it is not far off. We find that the current base rate level is too high given the financial and economic conditions, i.e. monetary policy is too tight and QE is justified and should be continued.