Sterling interbank lending rates fell on Tuesday as markets scaled back expectations for a UK interest rate hike after news that Britain's economy unexpectedly shrank 0.5 percent in the last quarter of 2010. Unusually poor winter weather accounted for only part of the economy's first shrinkage in five quarters and the Office for National Statistics said even without the disruption from Britain's coldest December in a century, the economy would have struggled to register any growth at all.
Short-sterling interest rate futures rose by almost 20 ticks across late 2011 and early 2012 contracts and two-year gilt yields fell by as much as 15 basis points. Benchmark three-month euro Libor rates fixed half a basis point higher at 0.97250 percent, while overnight rates were 13 basis points higher at 0.95 percent
The economic contraction challenges the viability of the government's severe austerity plan and leaves ministers at the mercy of a central bank under mounting pressure to act against inflation. "The Bank of England is in a difficult situation because its tools cannot address the downside risk to growth and inflation simultaneously," Regesta said.
The BoE has held rates at a record low 0.5 percent for 22 months but markets had been pricing in a 70 percent chance of a 25 basis point hike in May after UK inflation hit an eight-month high of 3.7 percent in December, with two rate hikes priced in by October.
"Today's very weak number will support our view that a rate hike before the fourth quarter of 2011 is very unlikely," said UniCredit economist Chiara Corsa. Sterling three-month Libor rates nudged higher to 0.77313 percent. In the eurozone, banks took 165.6 billion euros of 1-week funds, against a maturing amount of 177 billion euros, but are expected to take more than 50 billion euros of three-month funds on Wednesday, versus a maturing amount of 42.5 billion euros.