This week's MPC decision to set the tone for sterling

IN THE run-up to the Bank of England&rsquo;s interest rate and quantitative easing decision on Thursday, sterling remains extremely vulnerable to further selling pressure. The Monetary Policy Committee (MPC)&rsquo;s moves will set the tone for the pound, and for the wider currency market, going into the end of the year.<br /><br />Sterling has pared back some of its losses against both the euro and the US dollar over the past fortnight or so, but with the decision over whether to have another round of QE so finely balanced, it has been difficult and risky for forex traders to try to second guess the Bank&rsquo;s decision. So the market is waiting to discover the Bank&rsquo;s actual position this Thursday before moving all of its chips onto the table.<br /><br />The consensus in the City is for the MPC to add another &pound;25bn or so to the QE maximum &ndash; the form and pace of the asset purchases are another question entirely. Should this happen, then we could well expect to see sterling fall against both the euro and the US dollar in the wake of the announcement, as the market is split enough to bring about some large moves and volatility. <br /><br />Such strong downward pressure could see support in sterling-dollar retested at $1.6280 and $1.6255. A break below this level could open the way for further declines towards $1.6125 and then the $1.5710 early October low. And while the US dollar has been on a steady downtrend, the risk of additional QE is likely to impede sterling&rsquo;s ability to make further gains against the dollar ahead on Thursday.<br /><br />In terms of euro-sterling, the pair has already broken higher through initial resistance in the &pound;0.90 area to trigger further positive signals, suggesting that a recovery towards 0.9150 and then 0.9240 is under way.<br /><br />The fact that Britain remains stuck in recession while other countries are returning to growth, combined with the weak net lending and money supply figures, may well tip the balance in favour of further QE. The MPC may also look at the better-than-expected manufacturing purchasing managers&rsquo; index and the risk of inflation overshooting the 2 per cent target in two years&rsquo; time, and decide to hold back on further QE.<br /><br />If the MPC keeps interest rates on hold (or even if it adds another &pound;25bn to the QE pot) but the accompanying statement is very upbeat and suggests this would be the last round of QE, then there could be a mass reversal of short sterling positions, says Rishi Patel, head of FX trading at foreign exchange-provider FairFX. He adds that many are going to look for reasons to buy into sterling. &ldquo;We are overdue a significant retracement in the pound at the moment and I think parity with the euro would be an ambitious call. Sterling could well rally into the end of the year,&rdquo; he says. &nbsp;<br /><br /><strong>RALLY IN THE NEW YEAR</strong><br />And even if it doesn&rsquo;t rally before the end of the year, sterling is certainly very weak at the moment and we could well see a rally in 2010 as traders look to pick up the currency at good rates. <br /><br />Neither the Federal Reserve&rsquo;s Open Market Committee (FOMC) nor the European Central Bank (ECB) are expected to make any significant changes to their policies, although there could be a change in emphasis, particularly from the Fed this evening when it announces its decision, given the improving economic data. <br /><br />This places all the focus on sterling, but the looming MPC decision has made many traders wary of getting involved. However, there is bound to be plenty of volatility in the wake of the decision as traders look to reposition themselves in light of the new information. FX traders should be ready to take up the opportunity that is going to present itself later this week.