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The Bank of England concludes its May meeting today. We expect no change in interest rates or in the Bank's GBP 325 billion of asset purchases, however this decision will be particularly close due to the continued weakness in the UK economic data and deteriorating sovereign situation in the Eurozone.

Why would the BOE do more QE? The main reason is down to growth. The UK economy plunged back into recession in the first quarter of 2012, consumption remains weak, exports have fallen sharply and bank lending to businesses continues to contract at a 3.5% annual rate. This is worse than in the Eurozone, where lending is flat, and the US where lending is up more than 10% over the past year. This is hurting business growth and keeping upward pressure on unemployment. Thus, more QE could potentially loosen the channels of credit and may help to lift lending rates from their current lows.

However, while the growth backdrop is bad, at this stage the argument against more QE may be slightly more compelling for the BOE. Inflation remains above the BOE's target rate and prices remain elevated, which is constraining the consumer. Thus, more QE that could potentially generate even higher prices is not exactly good PR for the BOE.

Added to the inflation story, it's hard to justify more QE at this stage since the Bank has already pumped GBP 325 billion into the UK economy over the last three years and it didn't stop the UK from plunging back into recession. Gilt yields remain at some of their lowest ever levels as the Eurozone debt crisis generates safe haven flows into the UK debt market. Thus, GBP25bn or GBP50bn of more QE is unlikely to meaningfully push down Gilt yields or impact the economy.

However, going forward we think a couple of scenarios could develop that would justify more QE from the BOE. Firstly we believe that a strong pound could eventually weigh on inflation, thus allowing more QE from the Bank. Secondly, a major deterioration in the sovereign debt crisis, such as a disorderly Greek exit from the currency bloc could cause the BOE to take more action, just as it did in October last year.

However, if the Bank really wants to make QE effective, then it could mix up its asset purchases. Instead of buying exclusively Gilts, which already have enough buyers, it could try to buy other credit instruments that could alleviate pressure in the banking and housing sectors, like the Bank of Japan has tried to do with its Asset Purchase Programme. The Bank has not hinted it would vary its asset purchases, but this is definitely something to watch out for in the future, especially if the economy remains weak.

The impact on sterling:

 

As we mentioned at the top of this piece, the economic data clashes with the hawkish tone to the BOE minutes from the April meeting, making today's decision even harder to call.

We believe there is a slightly higher expectation of more QE from the BOE now than there was 2 weeks ago, so if the Bank holds as we expect this could be pound positive. GBPUSD has been moved around by overall risk sentiment recently, however, its ability to stay above 1.61 has been impressive. If the BOE remains on hold then we may test the recent 1.6180 highs before a potential re-test of 1.62. But continued strength in this pair will depend on overall risk appetite in the financial markets, and any strength could be used an opportunity to sell into.

EURGBP is a more attractive short position for us. This is fast approaching 0.8000 - a key support zone and a 22-month low. If the BOE remains on hold then this pair may break through this key level targeting 0.7900 next.

However, if the BOE surprises the markets and does more QE, expect this cross to react swiftly, and we could see a return to 0.8080 then towards 0.8150 as the pound gets sold on the back of a dovish BOE.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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