MONEY MARKETS-Bets on Bank of England rate cut seen overdone

By Kirsten Donovan

LONDON, Oct 8 (Reuters) - British money markets may bepricing in too high a chance of an interest rate cut in comingmonths with the Bank of England (BoE) expected to prefer othereasing tools such as expanding its asset purchase programme.

Forward overnight Sonia (sterling overnight interbankaverage) rates show markets pricing in around a 60 percentchance of a rate cut by next March, even though BoE GovernorMervyn King has said such a move would damage some financialinstitutions and thus be counter-productive .

The exaggerated expectations implied by current forwardSonia levels mean that these very short-term interest rates -which form the basis of lending costs to the wider economy - mayrise.

"It's difficult to justify why so much is priced ingiven that the macroeconomic impact of a 25 basis point cut maywell be very small...so the easing bias has to remain towardsconventional Gilt purchases," RBS rate strategist Simon Pecksaid.

Economists polled by Reuters expect the BoE to expand itsquantitative easing (QE) programme by 50 billion pounds ($81billion)in November .

"We're confident that more QE will come. Conviction for itcoming in November remains high," Peck said.

"Obviously, there is the risk of a pause but even if thereis, we still expect to get another 50 billion pounds."

That would take total asset purchases to 425 billion pounds.

Deutsche Bank used a model based on the 5-10 year portion ofthe gilt yield curve, taking into account other factorsincluding inflation, fiscal deficits and QE flow, and said itshowed the curve slope is too flat, implying another round ofasset puchases is largely factored in.

"In our view, (another 50 billion pounds of QE) is far lessobvious, with the FLS still to yet to take full effect, andgrowing concerns over inflation risks," the bank's strategistssaid in a note.

FLS refers to the BoE's Funding for Lending Scheme whichopened at the start of August and offers banks cheap finance ifthey increase lending to households and businesses.

With so much already priced in, Deutsche Bank recommendsmaintaining a short position in gilts, among other trades, aswell as betting on a widening in the spread between sterlingLibor and overnight interest swap rates (OIS) - currently at itstightest in over a year - versus the equivalent dollar spread.

RBS suggests moderating "overdone" interest rate cutexpectations by betting on a flattening of the money marketcurve by paying the February Sonia overnight rate and receivingpayments from the August 2013 overnight rate.

($1 = 0.6176 British pounds)

(Editing by Anthony Barker)

((+44 207 542 8675)(Reuters Messaging:kirsten.donovan.thomsonreuters.com@reuters.net))