A rebound in expectations that the European Central Bank will begin raising interest rates in April has opened up opportunities for investors ready to bet the less hawkish Bank of England will eventually have to catch-up. Euro interbank lending rates continued to rise on Wednesday, as ECB executive board member Lorenzo Bini Smaghi added to recent hawkish comments by fellow rate setters, reinforcing the view the bank will hike rates in April despite the disasters in Japan which some fear will affect world growth.
Meanwhile, BoE minutes on Wednesday showed he bank was no closer to raising rates in March, even though British inflation ran at 4.4 percent in February, almost double the rate in the euro zone. Analysts say pressure on the BoE to raise rates will grow if the ECB starts its tightening cycle in April. Another likely trigger for a repricing of UK rate expectations could be first quarter UK gross domestic product figures, due next month.
"I think the Sonia MPC curve is too complacent and having one hike priced in for between July and August is simply too late," said Matteo Regesta, rate strategist at BNP Paribas. "There's something like 10 basis points to gain by paying OIS with starting date at May's MPC."
UK overnight index swaps (OIS) implied a rate of 0.62 percent in May, and Regesta said they could pick up to 0.71-0.72 percent. He also suggested a play on the current lag between the UK and euro money market curves by selling December short-sterling futures against December Euribor futures, with a view that money markets will turn more hawkish in the UK.
The December short-sterling future was last trading at 98.560, while the December Euribor future was trading at 97.980. "Short sterling at 98.56 is too high given the fundamentals compared to Euribor, and probably the chances are that we're going to get even higher values from here for the UK, (which) means that this relative dislocation is worth exploiting," Regesta said.
Markets were looking at a parliamentary vote in Lisbon later in the day after which the Portuguese government could fall, renewing pressure on eurozone's lower-rated sovereigns.
But analysts say rate expectations are unlikely to be influenced by the outcome of the vote, as the ECB differentiates measures for inflation targeting from non-standard liquidity support measures.
"The element of political instability was already on the radar of the ECB when they were considering (signalling interest rate hikes), said Silvio Peruzzo, euro area economist at RBS. "They would intervene in the Portuguese government bond market, but I don't think it is an event that could trigger a delay in the normalisation of the (interest rate) policy."
April Euribor futures show the market expects the eurozone's benchmark rate to be trading at 1.305 percent in a month's time, compared to 1.270 percent expected before last Friday when ECB President Jean-Claude Trichet signalled monetary policy will not be affected by Japan's disaster. Euribor has traditionally traded at around 10-15 basis points over the benchmark rate, implying a high chance of a 25 bps hike in April is now priced in.