Sterling's fight

This is shaping up to be a key week for sterling. The Bank of England decided at last week’s policy meeting not to continue with bond purchases, an outcome which was largely as anticipated. But this leaves the market in a quandary as to whether this is merely a pause or an end to quantitative easing.

The economy has moved out of recession and at the same time, tomorrow’s inflation data is likely to show the headline rate on the up once again. Inflation has fallen for ten of the past 12 months, from 5.2% down to 2.2%. Since the financial crisis really kicked off four years ago, prices in the UK are up nearly 12%. This is twice the increase seen in the US, with eurozone prices up 7.5% over the same period. So is higher inflation going to be a negative for sterling?

It’s pretty clear that the dynamics of currency markets have changed a lot. Since more QE was announced in the US, the dollar has increased by 2%. Since the Bank of Japan announced plans to expand its balance sheet further at the end of October the yen is up nearly 1%. Indeed, sterling itself is up around 0.5% between July and November, during the Bank’s latest round of bond purchases.

Sterling has been tied up to sentiment on peripheral bond spreads. The short-term inverse correlation between EUR/GBP and spreads on peripheral eurozone debt increased sharply during September and October, at -0.52 on 1mth rolling measure. But this has been declining more recently, currently at -0.28. So, sterling has been showing some resilience to the general widening trend seen on borrowing costs vs. Germany. This suggests sterling is struggling with its perception as a ‘safe-haven’, or at least to the same as was the case before. This makes sense, because viewing sterling as a safe-haven still looks a stretch to many, given rising inflation, weak growth and continued austerity. For EUR/GBP, the technicals are still in favour of lower, but only modestly so, with next support seen at 0.7960, the 50% retracement of the July to October EURGBP recovery.

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