Markets may have got it all wrong on UK rate hikes

By Sumeet Desai - analysis

LONDON (Reuters) - Panicked by rising inflation, financial markets are betting the Bank of England will raise interest rates several times this year, but a slowing economy means the central bank's next move is more likely to be down.

After months of worrying about little more than a credit crunch-sparked global recession to rival the 1930s, investors now seem fixated with the prospect of a return of 1970s-style inflation as oil and food prices reach for the skies.

European Central Bank President Jean-Claude Trichet warned last week that euro zone interest rates may have to rise in July to curb inflation and Federal Reserve Chairman Ben Bernanke's tough talk has also raised the prospect of a U.S. rate hike.

Spooked by nightmare UK inflation numbers on Monday, 2-year swap rates in Britain jumped 30 basis points, the biggest rise since Black Wednesday September 16, 1992 when the then-Conservative government said it would jack up official rates to 15 percent.

Yields on two-year gilts have risen by nearly two percentage points since March and markets are betting on as many as three rate hikes ahead.

But rate rises don't seem likely even if inflation is already at 3 percent, a full point above the central bank's target, and expected to go higher still, because the economy is slowing and fears are growing of a housing market crash.

"Weakening economic activity is likely to help restrain second round effects from surging energy and food prices, preventing the need for the BoE to tighten monetary policy in coming months as the market currently expects," said Matthew Sharratt, an economist at Bank of America.

"(But) while we still believe that there is a slightly better-than-even chance that the BoE could resume easing late this year, the overwhelming risk is that, if oil prices remain at current levels, any monetary easing would be delayed into next year."