The British Pound saw an incredible reversal to end the year’s trade, as one of the darlings of global currency markets quickly turned into a primary victim of subprime-linked financial market duress. Indeed, the GBP initially scaled 26-year heights at $2.1160 before plummeting to its lowest in four months to end the year’s trading. The currency had initially rallied on hopes that the Bank of England would continue to raise domestic interest rates through the medium term, but increasingly poor financial market conditions and falling inflation levels allowed the central bank to actually cut rates for the first time in over two years. One of the clearest turning points for the GBP came when expectations shifted in favor of falling interest rates through the medium term. The chart below shows that the GBPUSD topped when yields on the 2-year Government bond fell below that of the 10-year issue. Such a yield curve inversion shows that markets expect that yields may continue to fall below their longer-term average through the coming two years, and it is relatively little surprise that the GBP would suffer on the yield curve inversion.
Overall momentum clearly remains to the downside for the British Pound, but subsequent outlook is likely dependent on the fallout from financial market difficulty and developments in the domestic economy. Namely, markets will look to see whether the UK housing market will suffer the same fate as its US counterpart through 2008, while traders will be keen to note overall implications for domestic interest rates. The domestic economy may also be particularly hard-hit by financial market troubles, as London represents a major hub for world financial institutions. Whether or not the UK economy can weather the storm will be the key question in 2008, but the outlook currently remains dim for the previously high-flying British Pound.
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[B]Bank of England Interest Rates: Where are Rates Headed Next?[/B]
The Bank of England forced a major shift in Sterling sentiment when they cut rates in December, and it remains relatively clear that they are likely to cut further through 2008. It is difficult to say exactly how many rate cuts are priced into interest rate futures, as general financial market duress has created significant risk premiums that distort interbank lending rates. Yet it is precisely this tightness in interbank lending rates that has given the Bank of England more freedom in cutting its short-term policy rate. Given an official short-term BoE policy rate of 5.50 percent, the 1-month London Interbank Offered Rate (LIBOR) currently trades at 6.50 percent—a whopping 100 basis point spread. These are the worst levels in over 15 years, and such elevated market borrowing rates truly underline the difficulty surrounding credit availability. Through the statement following the Bank of England’s December 6 rate cut, officials claimed, “conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead.” Indeed, continued difficulty for fallen market titan Northern Rock bank underlines financial institutions’ relative inability to cope with lending market illiquidity.
Bank of England rhetoric makes it clear that the authority does not intend to solve all credit and lending market duress through its official Bank Rate. Yet existing monetary conditions are clearly tighter than their 5.50 percent target aims to establish—arguably giving the bank ample room to cut its policy rate in order to achieve its monetary policy objectives. The Bank of England’s formal mandate dictates that it must keep the domestic inflation rate at the central bank’s target of 2.0 percent on a year-over-year basis. As such, officials will clearly react to any indications that price pressures will rise above or fall below such a measure. Recent inflationary readings suggests that the Bank may have some leeway in this regard, as year-over-year Consumer Price Index growth has hovered around the 2.0 percent mark. Yet the bank will be sure to watch for signs that inflationary pressures will increase through the medium term. In the meantime, dovish BoE rhetoric definitely supports such a muted interest rate outlook, but there remain key risks to the rate cut scenario. Namely, it will be important to watch whether the fallout from financial market duress and a looming housing market downturn will be enough to stem short-term price pressures in the UK economy.
[B]Housing market and financial market layoffs pose major risks to UK consumption rates[/B]
Real estate market growth forced major gains in UK consumption rates through 2007, but a looming downturn and the clear possibility of substantial fallout from financial market woes threatens to derail such spending trends. According to Rightmove Plc, average asking price for homes across the UK fell a whopping 3.2 percent through the month of December—the largest fall in the survey’s five-year record. Such a large and unexpected decline puts a damper outlook for the previously high-flying sector, and some economists now claim that the UK economy may experience a housing recession similar to that of the US. In a likewise similar note to the problems currently facing the US labor market, UK financial firms may look to shed jobs to cut costs in the face of a widespread shortage of cash. It is difficult to predict with any certainty the net effect that this will have on broader consumption trends, but the days of outsized financial bonuses and abundant job opportunities are clearly past. This may likewise affect real estate trends—especially in London, where financial payouts were reportedly responsible for much of house price inflation. As house prices look to fall, the availability of house equity withdrawals will go with them—limiting a key source of disposable income through years past.
[B]
Outlook for Bank of England Interest Rates Stands in Contrast to European Central Bank[/B]
The British Pound’s fast-shrinking yield differential against the euro has sent the EURGBP to record-highs through year-end trade, and overall momentum clearly favors further euro gains. Expectations for further Bank of England rate cuts have probably been the main driver for EURGBP rallies—especially as the European Central Bank looks to leave rates unchanged through the medium term. Subsequent outlook for the Euro-Sterling exchange rate will depend on developments for each respective central bank. As it currently stands, the scales certainly tip in the euro’s favor. Of course, quite a bit can change within a short time frame. Any risks that the Bank of England will not continue cutting interest rates could easily lift the Pound and take the EURGBP lower. At the same time, any noteworthy shifts in European Central Bank interest rate expectations could easily sink the euro against major counterparts. Such an ECB shift seems unlikely given continued hawkish rhetoric from key officials—especially as inflation levels remain at or above official targets of 2.0 percent for the broader euro area. If there are no significant changes to the status quo, it seems that risks remain further to the upside for the high-flying EURGBP currency pair.
[B]Key Points[/B]
Outlook and overall momentum remains bearish for the British Pound, but whether or not the currency may continue to decline will depend on several key factors. Indeed, developments in the GBP will very much depend on the future of domestic interest rates and relevant yield differentials against major forex counterparts. Markets feel that it is a near-certainty the Bank of England will continue cutting rates through 2008. Yet a persistent flare-up in inflationary pressures could easily dispel hopes that the BoE will lower rates further through 2008. Whether or not inflation will moderate through the medium term will subsequently depend on the effects of a nascent housing market slowdown and fallout from general financial market distress. If we see a UK housing market recession on the order of what the US is currently suffering, consumption rates will almost definitely fall. Likewise significant, substantial job cuts in the financial sector could just as easily hurt labor prospects and force a similar pullback in household spending. Risks to this outlook are many. If the UK housing market remains resilient and/or fallout from financial market troubles is contained, spending will likely remain robust in the broader economy. Given that slowing consumption rates are central to the Bank of England’s dovish outlook on price pressures, resilience in economic conditions could easily keep inflation at or above target through the medium term. Outlook on the pound will likewise depend on developments in other major economies. If the US Federal Reserve cuts rates more aggressively than the BoE, the GBP’s yield advantage could just as easily remain unchanged against the US dollar. Of course, further Fed interest rate cuts are clearly priced into futures prices and it may be difficult for the British Pound to rally significantly against its Cross-Atlantic counterpart.
[B]GBP/USD Technical Outlook: More Losses in Store – [/B][I]By Jamie Saettele[/I][B][/B]
We wrote last quarter that [I]“Cable remains well bid as the pair holds within a rising trend channel from the June 2006 low. The resistance line from this channel is just above 2.1000. A GBPUSD rally to 2.1000 or so fits nicely with a EURUSD rally to 1.44/1.4500 before a reversal of significant proportion.”[/I] After registering a high of 2.1160 on 11/9, Cable fell over 1,400 pips. The pair has broken below the channel that had remained intact since May of 2006 as well as the 200 day SMA (currently just above 2.0150). These developments warn of a significant trend change. Near term, the pattern is not especially clear but we do expect a drop below 1.9755 and possibly a test of the 161.8% extension of 2.1160-2.0353/2.0831 at 1.9525 before a bounce. That bounce will clarify the overall pattern and provide us with our bias for months. If the rally is an impulse, then we will get bullish against the registered low. If that rally is a correction in wave 4, then we will expect the decline to continue in wave 5. The bearish count is what we are showing on the chart.
