2012 Forecast: Sterling Has Potential to Weaken Against Euro

Similar to the euro, the British pound will likely weaken against the US dollar amid risk aversion in the first half of the year. Against the euro, the pound had gained for 3 consecutive years since 2009 although the magnitude has been declining. In 2011, EURGBP has been on a down trend since the EU summit as pessimism that EU finance leaders would not be able to derive effective measures to resolve the sovereign debt crisis has made sterling a safe-haven asset in the short-term. We do not expect this to continue this year as the UK has its own fiscal and economic problems to struggle. The disaster these might cause is not less than the debt problems in the17-nation region. An option to alleviate the economic problems would be monetary easing. Without the need of majority vote, the BOE may deliver more dovish stance on the monetary outlook than the ECB in 2012. This would then weaken the British pound.

Although UK's GDP grew +0.5% y/y in 3Q11 after climbing only +0.1% a quarter ago, the underlying trend is not at all encouraging. Manufacturing PMI data showed that the country's manufacturing activities remained in contraction. After peaking at 5.2% in September, headline inflation eased for a second consecutive month to 4.8% in November. It's expected that CPI will continue to decline in coming months as the VAT hike implemented in January 2011 will no longer have effect on inflation. Moreover, dismal global and domestic outlook will contain consumer spending, thus further facilitating moderation of inflation. The UK has to struggle with its own fiscal consolidation measures. The government has planned to lower the structural deficit by 8% of GDP and the primary structural deficit by 9% of GDP.

Despite the dismal economic outlook, the British pound has gained favor with overseas investors being attracted to the gilt market. However, the situation is unlikely to persist in the medium-term. Investors who have treated the UK as a substitute of the Eurozone should caution that a slowdown in the latter would weigh on the former. Moreover, while the credit rating in the UK remained supportive when compared to downgrades in various Eurozone countries (both core and peripheral), we doubt if the UK can maintain its AAA rating this year.

The BOE has kept the Bank rate at 0.5% since 2009. In order the stimulate growth under the ultra-low rate environment, the central bank embarked on asset purchase program in 2009 and increased the amount of purchases in November 2011 by 75B pound to 275B pound. As the UK has been emphasizing, a key advantage of not joining the Eurozone is independence of monetary policy. It's very likely that the MPC members will make well use of this independence to bolster growth this year, especially with the ease in inflationary pressure. We expect the policy rate will stay unchanged at 0.5% while the asset purchase program will be expanded by 50B pound, probably in the first quarter. It's also not surprisingly to see more dovish stance in BOE statements than ECB's.