Whether QE stays or goes, sterling is weak

THE big event this week for sterling is tomorrow’s decision from the Bank of England’s Monetary Policy
Committee (MPC). Up until last week, it had been widely expected that the Bank’s £200bn quantitative easing programme would be paused in February, but dismal fourth quarter GDP growth data raised the possibility that the MPC might extend QE further this month.

This makes the near-term outlook for sterling much more uncertain. So what would be the impact on sterling of the Bank’s decision on Thursday?

In terms of extending QE, well, the market thinks that it is highly unlikely. But bear in mind that the MPC knows things we don’t. It benefits from fresh growth and inflation projections, which will only be made public the following week in its quarterly inflation report. Barclays Capital analyst Paul Robinson says that while the GDP numbers have increased the likelihood of an extension of QE, it is still unlikely.

However, he adds that sterling would sell off sharply if further QE is announced on Thursday. Previous extensions of the asset purchase programme have caused sharp sell-offs in sterling-dollar. An extension would cause investors to push back their expectations of an interest rate rise, which would be negative for sterling. That the
Bank felt that further stimulus is required now, when many central banks are withdrawing liquidity support, this would also cause worry.

So does it follow that a pause in QE would boost sterling? Perhaps, in the immediate aftermath of the announcement, as investors might feel more comfortable about the UK economy’s prospects, and predict fiscal tightening will come sooner rather than later.

But there are two strong arguments that a pause in QE will not be bullish for sterling. First, the decision has been priced into the market. We may see a positive move for both sterling-dollar and sterling-euro, but this is expected to be short-lived. Second, given investors’ concerns about the UK’s budget deficit, a conclusion of QE is unlikely to do much for sterling in the longer-term, says Mark Bolsom, head of the UK trading desk at FX provider
Travelex. The government will have to issue around £225bn of gilts in the next fiscal year, but it will no longer be able to depend on the Bank of England to prop up demand. It will probably have to look to foreign funds to meet this demand, but overseas investors will only choose to hold sterling-denominated gilts if they are compensated sufficiently. This would require a rise in gilt interest rate differentials, which could hike domestic borrowing costs to unsustainable levels.

Investor concerns that the supply of government bonds will outstrip demand in 2010-11 could cause sterling to fall. Even a pause in QE will be sterling-negative. As Barclays Capital’s Paul Robinson points out, it is not a good idea to be long of sterling right now.