Is the gilt market sniffing out a Bank of England rate cut this week?

What’s this chart saying?

UK 2-year yields are down 3.3 basis points today in the sixth consecutive day of declines. The move comes ahead of Thursday’s Bank of England rate decision, with the rates market pricing in a 60% chance of a cut.

The Bank Rate is currently 5.25% so to get to 3.85% over two years, you need a significant amount of rate cuts. This is highlighting downside risks for the economy as the lagged effects of higher interest rates bite.

The pound has been tracking the move lower in gilts recently but is still close to the range-top of the past two years. A portion of that is due to US dollar weakness recently as the US faces its own growth headwinds. Some is also relief from the UK election and Labour promises not to raise corporate taxes or introduce a wealth tax.

In the short term though, it’s all about the Bank of England in what’s expected to be a razor-thin 5-4 vote either way. The BOE has repeatedly made the case that local wage dynamics and inflation dynamics are different from elsewhere so they could decide to wait another meeting before cutting.

Counter-intuitively, I think that kind of wait would be bearish for the pound as it would imply the BOE falling behind the curve and ultimately have to cut deeper later to avoid a worse downturn. Though I wouldn’t trade that theme with a great deal of confidence, it could be instructive as to what other central banks could soon face.

This article was written by Adam Button at www.forexlive.com.