Fundamental Outlook for British Pound: Bearish

- Bank of England delivers 100bps cut – as expected – to bring the benchmark rate to a 52-year low
-Service sector activity hits a record low as employment and new orders contract
- Manufacturing activity tumbled to a new low in November as the icy grips of recession take hold

The British pound has been acting tipsy just above its precarious support level at 1.45 against the US dollar. Data this past week was heavy hitting, but no surprises were generated from its collective impact. With risk sentiment holding to a range and technicals defining a clearer path for traders, it will take a significant fundamental shock to finally get the sterling moving – that is if a shift in risk trends or a broad move in the dollar don’t bet the market to the punch. There have been two primary drivers for the pound over the past six to nine months (interest rate speculation and growth forecasts) and these are likely to define trends going forward. The outlook for both rates and recession are particularly bad for the UK – perhaps the worst of the G10; but this may actually work in pound bulls’ favor. If the market is prepared for catastrophe, there is room for positive surprises (though the level of momentum and one ray of improvement may provide is a different issue).

Looking at the economic docket, the interest rate will be redefined; but it will naturally be less important. After a series of major rate cuts, the country’s benchmark lending rate is now at a mere 2.00 percent. This means that the Bank of England (BoE) has little room left to lower rates – a problem considering Governor Mervyn King has expressed concern that the economy could seen see a period of deflation (and combined with recession that leads to the dreaded stagflation – which far more difficult to recover from). On the docket next week, the Producer Price Index numbers for November will give an early reading on inflation trends. It is interesting to note that factory-gate prices between the UK an US are dramatically different, which could defer divergence in deflation expectations and shift the power in the currency market. As a benchmark, we now see that overnight index swaps measured by Credit Suisse are pricing in less than 50 basis points of additional easing over the coming 12 months. Everything else being equal, this is bullish as the pound will be in a better position when growth and the markets turn around and the appetite for yield returns. However we will see if they are that strong on the 12th.

The more prominent concern for fundamental traders at this point is the shape of the recession the UK is falling into. In a global economic slump, the United Kingdom is pacing the decline thanks to the late-to-reverse market and housing boom, a record level of consumer credit and the fact that London is the world’s financial center. It is true that growth projections are dour even from conservative parties (Chancellor of the Exchequer Alistair Darling expected an ongoing contraction through the first half of 2009 and the OECD has projected a 1.1 percent contraction through the entire year), but how long and severe will the slump actually be and what is the market currently pricing is are the real questions to price action for next week and beyond. We will see plenty data that will help gauge these level of sentiment. The BRC retail sales monitor – though relatively lagging – will provide a solid reading on growth ahead as it gauges consumer spending trends better than the volatility government reading. Before a real recovery in the economy can unfold, the housing market will have to pull out of its nose dive; and the RICS House Price Balance will tell us if that is a reasonable expectation. Finally, the NIESR GDP estimate will help define growth forecasts for traders that are more than weary over speculating against such an overwhelming trend.

David Rodriguez is a Currency Analyst at FXCM.