Markets bet on British rate cut, Gilts seen vulnerable if Bank of England disappoints

By Ana Nicolaci da Costa

LONDON (Reuters) - Financial markets are fully expecting the Bank of England to cut interest rates for the first time since 2009 on Thursday, meaning government debt could see a sell-off if the central bank is too tame.

BoE Governor Mark Carney was unusually explicit when he said after Britons voted to leave the European Union on June 23 that monetary easing was likely to be required over the summer, and markets were underwhelmed when rates did not change last month.

Minutes of July's meeting said most policymakers were likely to support looser policy in August, and surveys since then have shown the economy contracting at its fastest rate since the financial crisis, raising expectations for Thursday's decision.

Almost all economists in a Reuters poll expect the BoE to reduce borrowing costs by 25 basis points this week but they are divided on whether it will revive its bond-buying programme.

Peter Schaffrik, chief European strategist at RBC Capital Markets, said interest rate forwards were fully pricing in a 25 basis point rate cut on Thursday and some probability of a smaller rate reduction further down the line.

This left short-dated debt vulnerable to a fall. "I think the short-end is rich here. Unless (the BoE) cuts 25 bps or deeper than 25, and very clearly says we are going to cut again, what else can we price in here?" Schaffrik said.

"As with the short-end, the risk is to the upside for yields because we are priced for rate cuts. I think we priced in a fairly decent amount for some quantitative easing. If there is nothing, gilts will sell off."

Gilt yields traded in tight ranges on Wednesday, with investors reluctant to make big bets before Thursday's rate decision and the release of the BoE's latest economic forecasts.

Ten-year yields (GB10YT=RR) fell 1.7 basis points to 0.79 percent, off record lows of 0.686 percent hit last week. Gilt futures rose with Treasuries after the release of a U.S. private sector jobs report. [US/]

Two-year yields (GB2YT=RR) were little changed at 0.19 percent, well off the 0.063 percent level hit some days after the referendum, which was the lowest since 2012.

John Wraith, UK rate strategist at UBS, said it was difficult to gauge through market prices how far people were betting on quantitative easing, because of the sharp market reaction to Britain's vote to leave the EU.

"Some of the metrics that we would expect to move dramatically in the event of QE haven't really done very much. So we would say there is some expectation of QE but it's certainly not as strong as the expectation of a rate cut," he said.

He said gilt yields could head back to their lows if the BoE announced an "aggressive" round of quantitative easing, or something between 50 and 75 billion pounds of gilt purchases over the next three or four months.

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"I think some people are expecting that they will signal a readiness to do QE but maybe not restart it yet ... if it does happen and if it's relatively aggressive then that will be more dovish than the market was anticipating."

Sept long gilt future FLGcv1 129.80 (+0.17)

Sept 2016 short sterling FSSU6 99.66 (+0.005)

March 2017 short sterling FSSH7 99.71 (+0.02)