STERLING is trading near a 16-month high versus the euro and a new low for the year versus the dollar. Sterling strength versus the euro reflects demand for an alternative to the euro because of the EU debt crisis and the pound also benefits from expectations that the UK will maintain its AAA-rating as the EU faces downgrades and the decision not to join Eurozone. Meanwhile, the sterling-dollar decline reflects the negative UK economic outlook compared with the US economy and a close correlation to euro-dollar. Over the last few months, the correlation between sterling-dollar and euro-dollar is a relatively strong 0.74 where 1.0 would indicate an exact correlation.

The EU is the UK's main export market hence the strength of the sterling and weakening EU economy hurts UK export sales. At the end of 2011, UK data pointed towards possible improvement, however recent UK trade figures show that the trade deficit has widened as export sales have dropped and the weakness of the pound against other major currencies has caused the value of imports to rise. The decline of the pound against major currencies like the US, Australian and Canadian dollars makes it more costly for UK companies to do business in these countries. This coupled with government spending cuts, tax hikes and rising domestic inflation makes the investment environment in the UK negative.

A boost from the Bank of England (BoE) is needed to revive UK economic growth and this may encourage the central bank to soon implement additional quantitative easing. The BoE’s current asset purchase program stands at £275bn and we may see an additional stimulus of £25bn to £50bn announced at the February policy meeting.

If the BoE increases quantitative easing, the pound may experience more selling pressure versus the major currencies. Another round of asset purchases by the BoE may temporarily slow sterling gains versus the euro but is unlikely to reverse the current trend which is dependent on news from the EU. This suggests that as long as the negative news continues to pour out of the Eurozone it should present some opportunities to follow the trend and sell the euro-sterling pair which could soon be trading below £0.8000 while sterling-dollar may drop below $1.5000.

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