Crunch week to set the tone for sterling in 2013

IT IS a crunch week for the great British pound. The currency will be pushed and pulled by both monetary and fiscal forces. The market has been waiting with bated breath for today’s Autumn Statement, when chancellor George Osborne will outline his fiscal strategy to kick-start the UK’s ailing economy. There is also a chance that sterling could be shaken by the Bank of England tomorrow, as the Monetary Policy Committee (MPC) concludes its meeting.

The Office for Budgetary Responsibility’s (OBR) latest forecast, released at 1.30pm, is likely to make uncomfortable reading. Recent data suggests that the UK is falling behind on its target to reduce its structural deficit, and could fall short by as much as £12bn.

To address this, the chancellor has to make an awkward choice between tightening the fiscal belt further, or moving the goal posts again by extending the budget targets. The latter option seems more likely.

Currency traders will want a clear signal from Osborne that the government has a credible plan to bring public finances under control at some point, and to put the UK economy back on the path to growth. Anything less than absolute clarity may jeopardise the UK’s coveted AAA debt rating.

Rating agencies have shown remarkable patience with Britain’s lack of progress. However, Moody’s signalled that it will reassess the UK’s fiscal position in the early months of 2013. “The UK can only be given the benefit of the doubt for so long,” says Simon Wells of HSBC. He added that “if fiscal pain is kicked too far down the road, a downgrade is inevitable.”

HSBC argues that while gilts could shake off the impact of a downgrade – primarily because the UK is a “true sovereign” – sterling might not. The immediate reaction of a downgrade would be a fall in the value of sterling against its major currency peers. Traders would assess whether the downgrade is a symbol of further deterioration, and whether the government can muster a policy response. However, if a downgrade came in the midst of the US falling off its fiscal cliff, or a Eurozone meltdown, the effects could be muted.

It is difficult to know whether this has already been priced into the market. “It is pretty hazardous to try and anticipate exactly what number the OBR will publish,” according to Morgan Stanley, and Osborne could surprise us by pulling a rabbit out of the hat.

Although many column inches have been dedicated to the new Bank of England governor Mike Carney, he is not due to take office until July 2013. Till then, Sir Mervyn King still wears the crown in Threadneedle Street, and his outlook is what is important for sterling in the short-term.

Despite the likelihood that UK GDP will contract in the fourth quarter, the Bank is not expected to unleash another round of quantitative easing (QE) on Thursday. This isn’t surprising, given that it has agreed to transfer £37bn in accumulated coupon payments (earned through purchasing gilts via QE) back to the Treasury. Indeed, in its latest inflation report, the Bank said that this “will have an effect similar to the MPC purchasing gilts of the same value”. After the announcement, sterling’s reaction showed this, as it continued to slide against the dollar and breached $1.60.

In his latest testimony to parliament, King warned that more QE is on the cards. Howard Archer of IHS Global Insight says “with the economic recovery looking feeble and far from guaranteed, we continue to lean towards the view that the Bank will give the economy a helping hand with a final £50bn of QE” in early 2013.

Although QE has succeeded in keeping gilt yields lower, it has had a diminishing effect on boosting economic growth (see chart). Nevertheless, any announcement is still likely to be negative for sterling in the short-term.

Over the last year, sterling has broadly been trading in a range against the dollar, roughly between $1.52 and $1.62. For the most part, it is likely that this range will be respected over the course of 2013.

Goldman Sachs forecast that sterling-dollar will hang around its current levels at $1.60, and slide towards $1.56 towards the middle of next year, before bouncing to $1.65 by the year-end. However, Morgan Stanley think that sterling will gradually slip towards $1.54 over the course of 2013.

There is unlikely to be any positive news in this week’s assessment of the UK economy. Therefore sterling risks are likely to be to the downside for the foreseeable future, barring trouble in the US and the Eurozone, which could see sterling regain its appeal as a safe haven.