By Kirsten Donovan
LONDON, Oct 8 (Reuters) - British money markets may be pricing in too high a chance of an interest rate cut in coming months with the Bank of England (BoE) expected to prefer other easing tools such as expanding its asset purchase programme.
Forward overnight Sonia (sterling overnight interbank average) rates show markets pricing in around a 60 percent chance of a rate cut by next March, even though BoE Governor Mervyn King has said such a move would damage some financial institutions and thus be counter-productive .
The exaggerated expectations implied by current forward Sonia levels mean that these very short-term interest rates - which form the basis of lending costs to the wider economy - may rise.
"It's difficult to justify why so much is priced in given that the macroeconomic impact of a 25 basis point cut may well be very small...so the easing bias has to remain towards conventional Gilt purchases," RBS rate strategist Simon Peck said.
Economists polled by Reuters expect the BoE to expand its quantitative easing (QE) programme by 50 billion pounds ($81 billion)in November .
"We're confident that more QE will come. Conviction for it coming in November remains high," Peck said.
"Obviously, there is the risk of a pause but even if there is, 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 of the gilt yield curve, taking into account other factors including inflation, fiscal deficits and QE flow, and said it showed the curve slope is too flat, implying another round of asset puchases is largely factored in.
"In our view, (another 50 billion pounds of QE) is far less obvious, with the FLS still to yet to take full effect, and growing concerns over inflation risks," the bank's strategists said in a note.
FLS refers to the BoE's Funding for Lending Scheme which opened at the start of August and offers banks cheap finance if they increase lending to households and businesses.
With so much already priced in, Deutsche Bank recommends maintaining a short position in gilts, among other trades, as well as betting on a widening in the spread between sterling Libor and overnight interest swap rates (OIS) - currently at its tightest in over a year - versus the equivalent dollar spread.
RBS suggests moderating "overdone" interest rate cut expectations by betting on a flattening of the money market curve by paying the February Sonia overnight rate and receiving payments from the August 2013 overnight rate.
($1 = 0.6176 British pounds)
(Editing by Anthony Barker)
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Keywords: MARKETS MONEY/