Analysis: Sterling ready to extend recovery but ride rocky

By Neal Armstrong

LONDON (BestGrowthStock) – Sterling is poised for gains against the dollar as the chances of more monetary easing in the UK recede, although concerns about British banks’ exposure to euro zone peripheral countries may slow rallies.

The pound has bounced back from 2010 lows of $1.4228 as investors have welcomed the coalition government’s fiscal plans. With the UK unlikely to extend quantitative easing, analysts say widening interest rate differentials are likely to underpin the sterling’s recovery against other major currencies.

The U.S. Federal Reserve, the Bank of Japan are still easing monetary policy though QE, while peripheral debt problems in the euro zone could lead the European Central Bank to extend emergency measures in place since the financial crisis began.

In contrast, the Bank of England’s inflation report showed the central bank was worried about price pressures. While an interest rate hike is still far off, there seems no prospect of further easing, at least until early 2011, suggesting the pound’s recovery from 2010 lows has further to run.

“The inflation report was very cautious but it does look like the possibility for QE has been removed until the next report in February,” said Valentin Marinov, currency strategist at Citigroup.

“That should be supportive for sterling given potential for more widening in the swap rate differential between the UK and the U.S.,” he said, adding these differentials were a good proxy for the relative attractiveness of sterling and the greenback.

The spread of two-year UK swap rates over two-year U.S. swap rates stood around 105 basis points on Friday, well above the 2010 lows around 56.7.

Marinov saw potential for sterling to rise to the $1.65/1.67 area in the near-term, but he added that would depend on appetite for risk, which was becoming a function of developments in the euro zone periphery, such as the Irish debt crisis.

On Friday, sterling was trading at $1.6060, up more than 12 percent from its 2010 lows, but still below this year’s high of $1.6459 hit on January.

EXPOSURE TO EUROPE

One of the main factors checking the pound’s rise has been worries about British banks’ exposure to euro peripheral debt. Data from the Committee of European Banking Supervisors shows UK banks have a total sovereign debt exposure of 17.4 billion pounds to Greece, Ireland, Portugal and Spain, equivalent to about 1 percent of UK gross domestic product.

Majority state-owned Royal Bank of Scotland (RBS.L: ), for example, holds around 5 billion euros worth of Irish government debt and has more than 50 billion pounds as loans to homeowners in Ireland and Northern Ireland.

So even if a deal to rescue Ireland’s banking sector could provide short term relief to the pound, the risks of contagion and banks’ exposure to Portugal and Spain will play on investors’ minds.

“Cable is holding up well but there’s not much chance of seeing the upside while euro/dollar is being dogged by problems in the periphery,” said Gavin Friend, currency strategist at nabCapital. “In the near term the range is $1.57/1.63 but we do see it heading to $1.65 by the middle of next year.”

The pound has also made strong gains against the euro, pushing to a six-week high as declining QE expectations in the UK and worries over the euro zone periphery combined to drive the pair below 85 pence.

The euro’s 55-percent weighting in the BoE’s trade-weighted Exchange Rate Index has helped propel the pound to two-month highs.

“We are becoming more constructive on sterling. It’s coming from a cheap valuation and looks cheap on a trade weighted basis,” said Ankita Dudani, G10 currency strategist at RBS.

Indeed, long positions in sterling have jumped in recent weeks. Data from the Commodity Futures Trading Commission show that speculators’ long positions have more than quadrupled in a matter of three weeks as sterling bulls come back to the party.

TECHNICALLY BULLISH

Implied sterling/dollar options volatilities are at relatively low levels, indicating a market which seems comfortable with a steady rise in the pound. One-month vol trades at 10.2 not far from 2010 lows around 9.5.

The technical outlook for sterling is positive, with rising UK gilt yields providing support against the dollar.

“With UK yields rising in tandem with U.S. yields, we are not convinced that the uptrend off the May low is over,” said Phil Roberts, technical analyst at Barclays. “Provided support between 1.5850/1.5950 holds, we will continue to target 1.6185 and trendline resistance above at 1.6310.”

Roberts highlighted a double-bottom pattern in UK 10-year gilts, which he said was serving to underpin sterling against the dollar.

Analysis: Sterling ready to extend recovery but ride rocky