Fundamental Outlook for British Pound: Bearish

- UK House Prices Fall to Record Low in February, Says Rightmove
- Annual Inflation Beats Expectations, Prints at 3% in January
- British Pound Trades Higher as Retail Sales Unexpectedly Rise

The Gross Domestic Product report is the clear standout on next week’s economic calendar, with expectations calling for the economy to shrink -1.9% in the year to the fourth quarter, the largest drop in over 17 years. According to forecasts by the International Monetary Fund, the UK faces the worst recession among the G7 nations. The implications for the British Pound going forward could be dire as the Bank of England turns to unconventional measures to battle the downturn. Having cut borrowing costs by whopping 500 basis points since October to an all time low of 1%, Mervyn King and company revealed a reluctance to take rates lower in the minutes from the bank’s last policy meeting, fearing further easing would hurt bank profitability. Rather, the MPC voted unanimously to seek government approval for quantitative easing, saying “To the extent that further cuts in bank rate could not inject sufficient stimulus…the committee unanimously agree…to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money.”

Manually expanding the money supply could prove profoundly inflationary as the eventual recovery materializes and erode the Pound’s value if the central bank does not hike lending rates fast enough to drain excess liquidity. Policymakers’ recognition of a rebound tends to lag behind its actual beginning, threatening to put the BOE behind the curve. While it seems that some time will pass before Chancellor of the Exchequer Alistair Darling responds to the request and even longer before anything is implemented, it is important to note that markets are forward-looking and mostly trade on expectations of the future rather than the present. Having opened the door to quantitative easing, Mervyn King has now made the Pound vulnerable as any official comment interpreted to reinforce an inflationary scenario could send the currency tumbling.

Looking at the shorter term, trends in market risk sentiment remain an important driver of Sterling price action. GBPUSD is now 93% correlated with the Dow Jones Industrial Average and 96% correlated with the MSCI World Stock Index. Global equities shed -7.3% last week, the worst performance since the five days ending November 21st. Should risky assets retain downward momentum, the British Pound may well follow suit.

Antonio Sousa is a Currency Analyst for FXCM.