Rising real yields to protect Sterling from QE

The dovish tone of the Bank of England’s quarterly inflation report, released on Wednesday, in which the Bank said it expected economic activity to be broadly flat until the second half of 2012 and lowered its inflation forecast to 1.3% in two years, failed to have a significant currency effect. “The recent move lower in GBPUSD has been more a result of dollar strength rather than inherent sterling weakness”, says Elsa Lignos, senior currency strategist at RBC Capital Markets. “The pound has traded flat against the euro and our bias is still to the upside for sterling versus the euro.”

Despite GBPUSD breaching the 1.5820 support level earlier in the day, cable remained relatively resilient in the face of worse than expected employment data as well as the gloomy inflation report on Wednesday, while EURGBP registered only a small move higher, trading up only 30 pips from the 0.8540 open.

Traders said strong reserve manager buying had offset sterling weakness, with central banks in a position of strength over speculators looking to push cable through further technical levels.

Although the gloomy report on the UK economic outlook made the possibility of further aggressive asset purchases from the Bank of England more likely, sterling’s recent history indicates this may not pose a particularly great threat to the currency.

“Conventional wisdom suggests that quantitative easing should weaken the currency, as the central bank increases the supply of money but this doesn’t seem to match up with the price action”, says Lignos.

While Gilt yields have fallen in the month since the announcement from the already low level of approximately 2.4% towards 2.2%, the pound has appreciated on a trade weighted basis by nearly 2.5%.

“This is a very interesting reaction of the pound” says Peter Kinsella, FX strategist at Commerzbank. “One would normally expect the pound to depreciate as concerns of currency debasement abound, yet the opposite seems to be the case.” Indeed, the Bank of England’s own research points out that that not only was the “announcement effect” on sterling of its decision to engage in a first round of quantitative easing relatively small, but the longer-term effects of QE on the pound were marginal.

“With the most recent announcement of QE2 having had an even smaller impact you would be hard pushed to argue any further successive rounds will really weaken the pound” says Lignos.

While the pound is hardly poised for a massive rally given the weak UK growth outlook and the vulnerability of the British banking system, the currency may nevertheless benefit as real yields in the UK- currently among the lowest of G4 countries - look set to improve in coming months.

“In this environment the market will increasingly focus upon yield rather than growth and what is obvious is that inflation will not likely be one of the main issues running against the pound in the new year, hence the potential to outperform on a relative basis” says Kinsella.