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British Pound Selling to Continue on Interest Rate Outlook

British Pound Selling to Continue on Interest Rate Outlook

2010-02-27 03:53:00
Ilya Spivak, Sr. Currency Strategist
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Unlike many of its counterparts, the British Pound has looked past risk sentiment to trade on the most traditional of fundamental drivers guiding currency markets: interest rates. Indeed, near-term (20-day rolling) studies put Sterling’s correlation with the spread between December 2010 and March 2011 UK interest rate futures - a measure of where monetary policy will go in the first quarter of next year - at a hefty 0.88. This relationship saw the Pound underperform last week, producing the largest decline against the US Dollar relative to the other major currencies at 1.5 percent after an ominous set of fourth-quarter GDP figures. The report revealed a sharp decline in capital investment (3.1 percent) along with an unexpected surge in government spending (1.2 percent vs. 0.2 percent forecast). This fueled concerns about the soaring UK budget deficit and cast considerable doubt on the economy’s ability to maintain a self-sustaining recovery after the flow of stimulus cash dries up, hinting that monetary policy will have to remain accommodative for a long time yet.

Against this backdrop, next week’s interest rate announcement can do little than provide additional fodder for sellers of the UK currency. The Bank of England came out of February’s pivotal policy meeting looking every bit as dovish as before despite its decision to pause its asset-purchase scheme for the time being. Indeed, the quarterly inflation report that served as the basis for the outcome said that “the pace of recovery is somewhat less strong than [previously expected, while] inflation is likely to fall back to below the target” over the medium term despite a likely uptick above 3% in the first quarter as higher oil prices and sterling depreciation feed through. As for quantitative easing (QE), central bank chief Mervyn King explicitly said that although the BOE had paused asset purchases, “it is far too soon to conclude that no more purchases will be needed.” An extension of this wait-and-see approach seems likely this time around, although the risks for the Pound are to the downside should the central bank conclude that the precarious state of the economy warrants further action sooner rather than later.

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