GBP: Sterling Hit by Financial Jitters

What is new? Today the BoE took action in order to calm the red-hot money market through an emergency operation. The BoE said it will offer extra cash to commercial banks for the first time in six months to ease tensions in money markets. The bank will offer GBP 5bn of three-day reserves in an "exceptional" fine-tuning operation. In a following statement, the BoE said "this action is being taken in response to conditions in the short-term money markets this morning", and continued "the bank will take action to ensure that the overnight rate is close to bank rate. Along with other central banks, the BoE is closely monitoring market conditions''. GBP, which previously had weakened vis-à-vis EUR, fell slightly afterwards.

Where are we now? The BoE has so far lowered the base rate twice since December to 5.25 to guard economic growth from the derived effects of the US recession. Since price pressures have been evident and inflation expectations have risen, the cuts have been based entirely on considerations about the impact of credit tightening on the real economy.

On 3 January we wrote: "Because of the high importance of the UK financial sector (close to 10% of GDP), the credit crisis hits the UK economy harder than other European economies. The MPC is clearly worried about conditions in the financial markets and we think the BoE will remedy market participants in distress by lowering rates further, despite having refused to do so". We concluded that GBP would remain under pressure. This conclusion proved to be more right than anticipated and is still valid. So far, the BoE has upheld its hawkish stance and kept focus on inflation, but with the financial sector posing a serious threat to the real economy, we do not think this will continue much longer.

Important to watch further ahead

• Tomorrow (18 March) we receive CPI numbers for February. Forecasters expect energy and nonenergy industrial goods to post the largest contributions and the consensus expectation is for a 2.5% increase y/y, up from 2.2% y/y in January. Our model is, however, not in line with such a high reading. We acknowledge that oil, commodities and unit labour costs contribute positively, but according to the recent Eurostat numbers, price pressure seems to be easing. Inflation expectations look like they are stagnating, although at an elevated level, but the upward trend is clearly broken. Baltic freight contributes negatively. We expect that inflation will surprise on the downside, at 2.1-2.2% y/y.
• On Thursday (20 March) activity will probably show a marked moderation with retail sales only posting a 3.6% increase y/y in February, down from 5.6% in January. This confirms the picture of waning consumer demand.
• At the next Monetary Policy meeting (10 April) the BoE will lower the base rate by 25bp to 5.00%. The most dovish member, Blanchflower, has for some timed argued for lower UK rates in order to prevent a UK recession. The forthcoming minutes on 19 March will probably reveal that he was only voting for a cut at the last meeting, but the April meeting could be a very split decision. Some members may argue for unchanged rates (Besley, Sentence) and point towards price pressure in some parts of the economy, while some members - appropriately - will acknowledge the impact from the stretched situation in financial markets and propose a cut (Blanchflower, Gieve, Barker, Lomax, Bean, Tucker). The Governor, King, has had a hawkish stance for some time, and can potentially end in minority if voting for unchanged rates. This has, however, happened before and should not raise any concerns. We think the balance will tip towards a rate cut.
• Further ahead, the BoE will be forced to speed up the rate cuts. We have previously argued that BoE would only lower rates by 25bp at meetings followed by an Inflation Report. Given the seriousness of the global financial situation, this is now regarded as being too little, too late. The current market turmoil needs to be met by lower rates immediately and although the BoE might not be completely comfortable delivering this, the urgency of the situation justifies a pre-emptive move. We therefore expect 25bp cuts in April, May, June and two additional rate cuts in Q2 and Q3, taking the base rate to 4.00% by the end of the year.
• House price inflation is expected to turn negative in June. Too high rates, a plunge in financial equities and now the possibility of a crash in the housing market. Ring a bell? A worst-case scenario is that the UK turns into a mini-US. There are, however, still no clear signs of this and there are only a few obvious similarities. However, it should not be ignored that falling house prices will lower consumer demand and curb inflation.

We have raised our EUR/GBP forecast to reflect the current situation. We have called for a weaker GBP since the autumn of 2007 and the current forecast is still for sterling weakness. We now expect 0.79 at 1M (previously 0.77), 3M 0.80 (0.78), 6M 0.82 (0.78) and 12M 0.78 (0.76). Accordingly, we suggest selling GBP against safe haven currencies, CHF and JPY. We acknowledge that our short-term models suggest that the recent surge in EUR/GBP is overdone, but most of these models have difficulties in the current environment. Technical analysis suggests strong resistance around 0.8050 but does not rule out a move to 0.82. If carried out, it will be a return to pre-MPC levels, ie, new ten-year highs.

Danske Bank
http://www.danskebank.com/danskeresearch

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