Take a view on future interest rate rises with short sterling contracts

WHILE THE Bank of England&rsquo;s monetary policy decision on Thursday is almost certainly a done deal &ndash; everybody expects a hold &ndash; and is not expected to shock the market, there is no doubt that everybody in the City will be watching the Monetary Policy Committee&rsquo;s (MPC) accompanying statement for indications of a more upbeat tone and potential interest rate hikes in the near future.<br /><br />Despite the Bank of England sounding rather dovish on the outlook for interest rates and policy tightening in general, the market has been pricing in a rise in interest rates as early as the first quarter of next year, on the basis that the economy will have started to recover by then. Investors are increasingly becoming more positive about the prospects for the UK economy and there are growing signs that quantitative easing is working. Of course, not everybody agrees. Most economists believe that the rate-hikes will come later, perhaps around the end of the second quarter.<br /><br />Whatever their views, contracts for difference (CFDs) traders can take a view on when they expect rates to start rising, and how quickly, by taking positions on short sterling contracts, which is based on the expectation of three-month interest rates futures contracts and offered by many of the big CFD providers.<br /><br />While the lack of movement since February in the Bank of England&rsquo;s base rate has seen activity in short sterling CFD positions wane, WorldSpreads&rsquo; Alastair McCaig says that we may get a bit more interest in these contracts as the year progresses.<br /><br />The way it works is that the value of a short sterling contract is calculated using Libor (the London Interbank Offered Rate) by subtracting the average expected interest rate from 100. Therefore, an expected rate of 2 per cent would see the contract trading around the 98 mark. The September 2010 contract is currently trading at 97.99-98.09, which indicates that the market does indeed expect interest rates to reach as high as 2 per cent by this time next year.<br /><br />If you believe that interest rates will go up earlier than the market is currently predicting, then you would want to sell the March 2010 short sterling contract &ndash; there is an inverse relationship between the value of the contract and the interest rate. <br /><br /><strong>LIMITED UPSIDE</strong><br />On the other hand if you believe, like many economists, that the MPC will keep rates on hold until this time next year then you would look to buy the contract now on the expectation that short-term interest rates will not rise as sharply as is currently thought. But bear in mind that there is limited upside to buying at the moment as the value of the contract cannot exceed 100.<br /><br />However, short-term interest rate futures contracts are not just affected by the decisions taken by the Bank of England, says Richard Turner, FX sales dealer at IG Index. The rate at which banks lend to each other, credit expectations and relationships between banks can equally drive the contract&rsquo;s value up and down.<br /><br />For example, he says that the recent threat that the Bank of England would adopt the Swedish Riksbank&rsquo;s model of charging for banks&rsquo; deposits held at the central bank was bullish for the near-month (September 2009) short sterling contract. This is because banks will have to start lending more freely and pushing up the supply of money circulating in the economy.<br /><br />The most important thing to decide when trading short sterling contracts, says Turner, is to choose your timeframe carefully. IG have contracts going as far into the future as June 2011, so there is plenty of opportunity for you to take a view on interest rate expectations, whatever your view.