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Tough economic climate and fiscal laxity to keep pressure on sterling

JANE FOLEY
RESEARCH DIRECTOR, FOREX.COM

IN CONTRAST to last month’s meeting, today’s decision by the Bank of England has not been billed as a headline event. February’s meeting had a much higher profile, thanks to its coincident timing with the quarterly inflation report, which gives the central bank a fresh set of growth and inflation projections and made a decision on quantitative easing (QE) far more likely. In the event, QE was paused.

But since that meeting, various Bank of England officials have been at great pains to drive home the point that a pause means a pause and that the door to QE is still open. This will make both today’s meeting and the one in April a little more interesting. It is likely that any major decisions about QE will still coincide with the quarterly inflation reports because of the new forecasts that these give the Monetary Policy Committee (MPC).

However, some discussion on the topic of QE by the MPC is possible in both March and April and the minutes of these meetings will be closely scrutinised for any such information. Given that the Bank may still announce further policy loosening, there is little chance of any increase in interest rates any time soon. Although we have had an upward revision to fourth quarter GDP, a better outcome from consumer confidence data and signs that the manufacturing sector may be picking up since the February meeting, UK economic data is, on the whole, describing an economy that is facing another tough year. And taking into account the Bank of England’s benign inflation outlook, it is reasonable to expect that it may not raise rates until the very end of this year or even until 2011.

While data is showing some improvement, the breakdown of fourth quarter GDP shows that the 0.3 per cent quarterly growth was largely due to government spending, which rose 1.2 per cent on the previous quarter. This highlights the risk of a double dip recession in the UK if too much austerity is introduced after the general election. On the other hand, if no austerity measures are announced then we could see a potential funding crisis and this would be just as grim. The increase in gilt yields as a result of the UK’s budget deficit has helped to attract buyers at recent debt auctions but the extra costs to the government of issuing this debt will only increase the UK’s debt burden.

Concerns about growth and the fiscal deficit were largely responsible for sterling’s recent collapse against the US dollar. While a weaker sterling could help growth by boosting exports, fears of a persistent decline in the pound will further undermine the attraction of gilts and increase the possibility of a funding crisis.

Opinion polls persist in pointing out the chances of a hung parliament, which is only adding to sterling’s woes. This possibility was first flagged at the end of last year but with only two months or so to go before the general election, this risk is appearing more real. The market’s concern is that a coalition government will only make the deficit in the UK worse. This happened in countries such as Belgium and Italy before they joined the Eurozone. The market’s preference would be for a strong UK government bent on budget reform. If this outcome is looking unlikely, then the yield curve could steepen further and sterling may have further to fall.

Email Jane Foley with your comments at researchemea@forex.com. Read daily market commentary and analysis from Jane Foley and the FOREX.com global research team at www.forex.com/uk.

CENTRAL BANK DECISIONS | EUROPEAN CENTRAL BANK
The European Central Bank (ECB) is also scheduled to make its monthly monetary policy decision today. It will be overshadowed by measures to solve the ongoing crisis in Greece but the press conference at 12.45pm should be interesting.

Like the Bank of England, the Eurozone central bank is expected to leave interest rates on hold at 1 per cent. Recent data has proved particularly disappointing – Germany stagnated in the fourth quarter of 2009 and yesterday’s services purchasing managers’ index for the bloc showed a slowing pace of expansion.

However, there is a chance that the ECB will make liquidity decisions to be presented at the subsequent press conference. A number of economists expect the ECB to end provision of its six-month refinancing operations this week and it may also raise the rate on its three month loans to commercial banks.