British Pound Remains Heavy As Declining Yield Expectations and Risk Aversion Weigh

GBP/USD

BoE Governor Mervyn King hinted at the possibility of more quantitative easing today in testimony to Parliament today which sunk the outlook for U.K. interest rates. The MPC is expected to remain on hold despite inflation well above their 2% target at 2.9% as they see a protracted recovery. The pound tumbled following the central bank’s last policy meeting as markets were expecting an end to the asset purchase program. Now that it is apparent that despite rising consumer prices a rate hike is unlikely in the near-term, yield expectation have lost their influence on price action with its correlation falling to 17% from 27% a week ago. Risk trends continue to dominate direction explaining 48% of volatility with U.S. interest rate expectations seeing an increase in importance following the Fed’s raising of the discount rate.

BoE Interest Rate Expectations

Overnight Index Swaps have seen expectations for a rate hike plummet with markets now only expecting 38 bps of tightening over the next twelve months. The prospect of additional QE will continue to depress the yield outlook for the U.K. which should continue to weigh on the pound.  An expected upward revision in fourth quarter GDP on Friday could help limit downside risks and generate bullish sentiment. The MOPC will meet next week to determine future policy and considering today’s dovish comments we may see sterling weakness heading into the policy meeting. To discuss this and trading ideas join the GBP/USD forum.

FOMC Interest Rate Expectations

Fed funds futures continue to point toward the FOMC remaining on hold until after August, despite the raise in the discount rate. We did see overnight index swaps shoot to 108.8 from 70 on the unexpected policy action but have since returned to 71.5. Markets see zero chance of a March rate hike with April at 9.1%. It may take a sharp rise in inflation or a developing positive trend in job growth to push policy makers off their current stance. A sharp drop in consumer confidence sparked broad based risk aversion as growth expectations dimmed. The lack of job growth has led to increasing pessimism by Americans and unless unemployment begins to fall the central bank may be forced to remain on hold. Fed chairman Ben Bernanke will face lawmakers tomorrow to discuss the central bank’s exit strategy from liquidity efforts. The weak labor market has politicians weary that becoming too aggressive could jeopardize the recovery.

Risk

A dismal U.S. consumer confidence reading sunk equity markets, which could be a catalyst for a longer-term bearish trend. Broader pessimism is increasing as budget deficit troubles in Europe continue to trouble investors and the outlook for growth dims as governments start to unwind liquidity efforts. Downside risks appear to be increasing for stocks which could drag an already heavy sterling lower. Trend line support could help slow losses which could foster a period of consolidation for the pound ahead of the BoE rate decision. To discuss this and other fundamental data join the Economics Forum.

To discuss this report or be added to the email list contact John Rivera, Currency Analyst: jrivera@fxcm.com