Play the Bank's QE decision with a punt on gilts

THIS year we have witnessed the Bank of England take the unprecedented step of buying billions of pounds worth of assets &ndash; mostly government bonds &ndash; in order to loosen monetary policy further than can be achieved through interest rate cuts alone. <br /><br />It goes without saying that this policy of quantitative easing (QE) has had a major impact on the gilts markets, creating artificial demand for government debt but also helping to mop up some of the bonds that the government has had to issue to finance its huge budget deficit. The result has been a slump in gilt yields, which move inversely to their price. <br /><br />So with everybody in the City wondering what the Bank of England has up its sleeve for the next Monetary Policy Committee (MPC) &ndash; held on 4-5 November &ndash; how can spread betters look to take advantage of it?<br /><br />Most spread betters would&nbsp; choose to day trade the indices and sterling as the market reacts to the news but you could also take a longer-term view about where interest rates are going by getting involved in the bond markets. All the major providers such as CMC Markets and City Index offer spread bet markets based on bonds and three-month short sterling. Government bond futures allow spread betters to take a punt on the long-term rise or fall of interest rates, with all the main markets available, including UK gilts, German bunds and US Treasuries.<br /><br />Spread betting in bonds and short sterling used to be far less popular than other asset classes simply because they appeared too complex and you didn&rsquo;t see as much about them in the press, compared to the FTSE 100, or oil and gold.<br /><br />But the Bank of England&rsquo;s QE programme has certainly changed that. The gilt market has become more mainstream in the past year, such is the importance of the asset purchase policy.<br /><br />And what impact could the MPC&rsquo;s decision have on government bond prices and yields?<br /><br /><strong>LOOSEN POLICY</strong><br />Given that the MPC has said that interest rates are likely to remain low until well into 2010, a hike in the base rate would be extremely unlikely at this stage. The MPC then effectively has four options: to hold again; to loosen monetary policy further by extending QE beyond the current maximum of &pound;175bn; to pause QE; or to start tightening monetary policy by gradually reversing the monetary stimulus by selling gilts.<br /><br />Following Friday&rsquo;s dire and unexpected GDP data, which showed that the UK contracted further during the third quarter by 0.4 per cent, the MPC will be loathe to start tightening and the disappointing growth figures may even tip the balance towards further QE in November. <br /><br />Richard McGuire, senior fixed income strategist at RBC Capital Markets, says: &ldquo;The clear indication here that the UK remains mired in an unprecedented recession provides a compelling argument in favour of the BoE opting for a precautionary increase in the QE limit come 5 November.&rdquo; <br /><br />He adds: &ldquo;While this week&rsquo;s minutes saw a &pound;25bn increase looking like the most the Bank would do, today&rsquo;s number arguably brings the risk of more aggressive action back into view.&rdquo;<br /><br />In this scenario, we would expect gilt prices to rally further &ndash; and yields fall &ndash; as the Bank of England is demanding more bonds. UK gilts and short-sterling interest rate futures rallied on Friday as traders sought to price in the greater likelihood of an extension to QE. <br /><br />Spread betters who think that the MPC will extend its asset purchase policy and effectively reduce interest rates further should look to go long on short sterling or on UK gilts. <br /><br />On the other hand, a number of notable City economists have been arguing that a pause in QE is now needed, given the better global economic situation, rallying equity markets and a weaker sterling. <br /><br />Simon Ward, chief economist at asset management firm Henderson New Star, said: &ldquo;The two-year-ahead inflation projection based on unchanged policies was above the target at 2.17 per cent in August so the MPC needs to conclude that inflation prospects have improved to justify extending asset-buying. This still looks a stretch, even after today&rsquo;s number.&rdquo; <br /><br />So if the Bank of England were to pause QE, then market participants would look to price in lower expected demand for gilts and we would therefore see a fall in prices and yields should rally.<br /><br />There is ample room for fireworks&nbsp; on 5 November when the MPC will announce its decision. Even if it makes a move that has been anticipated by some traders, there is little true consensus in the market. This means that we are likely to see a sharp move on the day as market participants scramble to reposition themselves. Day traders should see this as an opportunity to make some decent-sized profits.<br /><br />Prepare yourself for sparks and you could see your profit rocket.<br /><strong><br />WEEK AHEAD ECONOMIC DATA<br />Tuesday 27 October<br /></strong><br /><strong>UK:</strong> October CBI Distributive Trades Survey (11am)<br /><strong>Eurozone:</strong> October broad money supply growth (9am)<br /><strong>US:</strong> August S&amp;P/Case Shiller composite home price index (1pm) and October consumer confidence (2pm)<br /><br /><strong>Wednesday 28 October<br /></strong><br /><strong>Germany:</strong> CPI for October (varies)<br /><strong>US:</strong> September new home sales (2pm)<br /><br /><strong>Thursday 29 October</strong><br /><br /><strong>UK</strong>: September net lending and mortgage approvals (9.30am)<br /><strong>Eurozone</strong>: October business, economic and consumer confidence indicators (10am)<br /><strong>US</strong>: Third quarter GDP growth (12.30pm)<br /><br /><strong>Friday 30 October</strong><br /><br /><strong>UK</strong>: October GfK Consumer Confidence (12am)<br /><strong>Eurozone</strong>: CPI estimate (10am)