UK CPI at 4.4% y/y is more than twice as high as the BoE's 2% inflation target. The strength of headline inflation suggests there is clear risk that one more MPC member will have joined the hawkish camp this month.

That said we place a greater probability on the likelihood that the vote in favour of steady policy will be 6:3 in line with last month. We expect that most MPC members will prefer to see the initial impact of the April austerity measures before voting to hike interest rates.

Today's budget has been themed by the government as a Budget for Growth. Despite disappointing February public sector borrowing data released yesterday, the cumulative budget deficit for the first 11 mths of the fiscal year is still better than forecast.

With just one month to go before fiscal year end, this is expected to provide the Chancellor with room for a small budget sweetener, estimated to be in the region of GBP 5 bln. That aside, the Chancellor's hands will be tied by the coalition's pledge to rein in the budget deficit.

While the government may spend this £5 bln or so to help ease the plight of squeezed motorists or middle income earners, much of today's reforms are forecast to be in the area of loosening regulation. Sweeteners aside, there is no avoiding the fact that the already announced round of April austerity cuts will leave almost no one in the country unaffected and that the economy faces potentially severe headwinds this spring.

UK VAT was raised from 17.5% to 20% in early January. Measures that will impact in April include a lowering of the threshold for higher levels of income tax, increases in fuel and alcohol duty, a two year public sector pay freeze and a cap on the total level of social security benefits.

These measures will intensify the erosion of wages already caused by higher fuel and food prices. On top of the changes to tax and benefits 300,000 public sector workers are expected to lose their jobs over the next 4 years. Labour data suggests this reshape has already started.

The market is currently priced for a BoE rate hike in July. We continue to favour a move in Q4 as more likely. On our view, GBP is a sell on rallies vs. the EUR. We look for a move towards 0.89 on a 6 mth horizon.

EUR/USD stalls, but find support

The FX market switched attention back to the ongoing EMU crisis yesterday; EUR/USD failed to push above the 1.4250 level. There is real risk that the Portuguese government could collapse this week which would push the country even closer to requesting a bail-out. Concerns about Portugal's ability to repay its debt continue to be reflecting in the bond market.

The impact on the EUR, however, remains muted; with market sentiment apparently reflecting the view that Portuguese issues do not have the fire-power to bring EMU to its knees. While the market appears to be taking the view that EMU is here to stay, USD weakness is a significant contributor to the current relatively buoyant position of EUR/USD.

A weaker oil price would have the potential to support the USD. However, the ongoing Middle Eastern crisis in addition to accommodative Fed policy suggests EUR/USD is likely to head higher medium-term.

Disclaimer

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