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Rebound in GBPJPY creates renewed selling opportunity, says Morgan Stanley

Morgan Stanley claims investors have renewed medium-term selling opportunities thanks to GBPJPY rebounding above 120 in the current risk-on environment, as the downside risks to sterling remain strong.

GBPJPY was no exception to the rebound in the current risk-on environment, as fears of a US recession abated following Friday’s positive employment data in the US and the weekend’s Merkel-Sarkozy pledge to establish a long-term solution for the eurozone’s debt crisis by the end of the month. However, much of GBPJPY’s upward move should be viewed as a corrective recovery of recent sharp sell-offs, say analysts at Morgan Stanley, and investors are advised to stay positioned for further sterling downside against the yen.

Analysts recommend using rebounds into the 120.90 area to establish bearish positions, with a stop at 122.90, targeting 116.00.

Following the Monetary Policy Committee’s surprise announcement on October 6 to add another £75 billion-worth of asset purchases to the Bank of England’s balance sheet, GBPJPY immediately fell 1.3%. But the currency pair began to retrace the moves aided by positive headlines and has since gained 2.74% since Thursday’s lows.

 GBPJPY (06/10/11 - 10/10/11)
 Source: Bloomberg

However, the broad improvement in risk sentiment may have carried GBPJPY too high, given the risks that still face sterling. Economic data coming out of the UK has been weak, with the latest data revisions showing that the UK economy grew by only 0.1% in the second quarter. The economy’s fragility was once again reiterated after the most recent employment confidence report showed Briton’s confidence in the employment outlook fell for the third successive month in September to its lowest level since February. The effectiveness of QE also depends on the extent to which the monetary transmission mechanism passes through the banking sector, and analysts at Morgan Stanley say the central bank’s asset purchasing will likely weigh heavily on sterling if the system is too distressed to efficiently process the excess liquidity.

“With the banking sector weak and local credit multipliers broken, direct asset appreciation is unlikely,” says Hans Redeker, head of global FX strategy at Morgan Stanley. “Consequently, the currency market may have to bear the main burden if QE is to be successful.”

The latest data from BoE also shows that overseas investors have become net sellers of gilts. This means the currency may be particularly exposed to QE this time around, as the Bank sells sterling to meet the new target of £275 billion for the total asset purchase programme, almost 18.5% of GDP.

The surprisingly aggressive move by the BoE, as well as governor Mervyn King’s accompanying statement – in which he said “this is the worst financial crisis since the 1930s, if not ever” – exemplifies how MPC members remain very dovish in comparison to other central banks.

With little manoeuvrability using conventional monetary policy, further QE may be possible if the economic outlook in the UK does not show signs of improving, giving investors little reason to buy Sterling.

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