Sterling’s rebound set to run out of steam

By:
Peter Garnham
Published on:

Sterling has found some support since GBPUSD broke down through $1.50 at the start of March, but could come under renewed pressure in the coming weeks.

GBPUSD fell to a near three-year low of $1.4855 on March 12 but has since bounced, sitting just under $1.53.

Sterling’s pullback was helped as investors covered short positions after the Bank of England (BoE) indicated it was not pursuing a policy of currency debasement to promote growth. Meanwhile the liquidity driven rebound across financial markets, helped in part by the Bank of Japan’s plans to increase its balance sheet massively, also provided the pound with a boost.

However, sterling now faces a number of headwinds.

Those include last week’s downgrade of UK government debt from AAA to AA+ from ratings agency Fitch, which came after the IMF suggested UK chancellor George Osborne should slow down his austerity programme in a bid to boost growth.

That has come amid recent signs that UK economic activity is slowing – such as disappointing retail sales and labour market data.

It also comes amid signs of increased dovishness from the BoE.

Monetary Policy Committee member Martin Weale, for example, who has been in the majority on the three occasions the Bank has increased the size of its asset purchase plan, last week played down the inflationary pressures in the UK economy, highlighting the scope for further easing measures.

Of course, a big test for sterling comes this Thursday as first-quarter GDP figures will reveal whether the UK has entered into a triple-dip recession.

Of the 37 economic research teams forecasting the release surveyed by Bloomberg, only six expect a negative print.

One of those is Morgan Stanley, which is predicting a contraction of 0.3%, below the consensus forecast for 0.1% growth.

Ian Stannard, head of European FX strategy at Morgan Stanley, says if that contraction occurs the chances for another round of quantitative easing (QE) from the BoE, possibly as early as its meeting on May 9, will rise markedly, leaving sterling vulnerable.

“We expect a potential return to QE to be a negative factor for GBP, unlike the previous round of easing where safe-haven flows from Europe proved a supportive factor,” he says.

 Sterling has found haven support during previous bouts of QE
 
Source: Morgan Stanley 

Those safe-haven flows were most evident during the October 2011 to May 2012 round of QE. During that period, eurozone bond spreads widened sharply and there was clear evidence of flows into safe havens taking place.

Stannard notes that late 2011 through to mid-2012 was also the period with the fastest pace of Target2 imbalance growth – increasing divergence between German and peripheral eurozone countries’ balances at the European Central Bank – and the most rapid expansion of the Swiss National Bank’s FX reserves.

Hence, sterling gained support through that particular round of BoE QE, with trade-weighted sterling becoming closely correlated to eurozone bond yield spreads.

“However, in the current environment, with stabilization in asset markets at the periphery of the eurozone and spreads coming down, we would not expect the offsetting safe-haven flows seen previously during rounds of quantitative easing from the Bank of England,” says Stannard.

That, he says, suggests that sterling would be left in a more vulnerable position should the BoE embark on a renewed round of easing, while the latest downgrade of the UK’s credit rating should also weigh on foreign demand for UK assets.

The technical picture also looks negative for GBPUSD, according to Stannard, with the fact that the rebound from the lows around $1.4850 in mid-March were contained to the $1.5410 level it hit in early April, meaning the gains during the past month have been a correction and that the broader downtrend from the high of $1.6380 GBPUSD hit in January remains intact.

Morgan Stanley has a year-end forecast of $1.43 in GBPUSD. First, however, sterling will have to break down through this year's low.