Outlook for the British Pound: UK currency supported by capital inflows, but there are risks on the horizon warn analysts

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Category: Featured

Published on Thursday, 29 March 2012 10:56

Written by Will Peters

The British pound (Currency:GBP) has enjoyed strong gains against the US dollar and Euro recently, largely on the back of 'substantial' capital inflows; Bank of America Merrill Lynch Research notes that short positions on the UK currency are also being unwound by hedge funds.

But, analysts Richard Cochinos and Nick Bate warn that the case for all-out sterling gains is yet to be made:

"Despite GBP being the second-best performing currency this month in the G10, we think there is a large difference between unwinding shorts and establishing outright long positions. By our metrics, real money is currently flat and hedge funds hold only a mild long."

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Indeed, BofA Merrill Lynch worry that downside risks may not be fully reflected in GBP’s recent strength.

Also supporting the British pound are market expectations for quantitative easing at the Bank of England have been fully priced out by the currency markets.

However, it must be remembered that two Monetary Policy Committee (MPC) members continue to vote for more QE, trends in the UK’s data remain soft and Governor King recently commented that even he did not know if more QE will be needed.

Additionally, a longer-term risk has been building in the stock of gilts held by international accounts.

"We expect gilt flow will be a more significant driver for GBP than it has been in the past due to the client base holding this debt," says Bate and Cochinos.

It is worth noting that data from the UK’s debt management office (DMO) highlight that international investors held over 32% of outstanding gilts as of Q3 2011, compared to just 20% five years ago.

In terms of notional holdings, at £355bn, the overseas investors have now surpassed UK insurance companies and pension funds – historically the bread-and-butter purchasers of gilts.

Cochinos and Bate say that this shift in the distribution is significant for foreign exchange, as these investors are non-GBP denominated, whereas insurance companies and pension funds are typically domestic and have little impact on the currency.

Bank of America estimate there could be around a 40% chance of the UK being downgraded from its current AAA status over the next few quarters.

"Moreover, further deterioration in either UK or Euro area growth prospects could result in markets pricing in a UK downgrade ahead of any actual change from the ratings agencies. To keep these numbers in perspective, a 15% reduction in the stock held by non-official international accounts would equate to a negative £42bn outflow," says Bate and Cochinos.

And, in an event of a downgrade, we should expect the pound dollar exchange rate to be hit harder than the pound euro exchange rate.

"A renewed deterioration in the Euro area would likely pose greater risks to the UK economy (and sovereign rating) than the US, pushing down GBP-USD where EUR-GBP could remain range bound," says the currency note.