Fundamental Forecast for the British Pound: Neutral

The bullish breakout in the British pound may gather pace in January as it carves out a bottom during the holiday trade, but the exchange rate may consolidate over the following week as the economic docket is expected to reinforce a weakened outlook for the U.K. As the GBP/USD crosses back above former support around 1.5500, with the relative strength index bouncing back from a low of 33, the pair may continue to retrace the decline from December as market participants speculate the Bank of England to gradually normalize monetary policy in 2011.

According to Credit Suisse overnight index swaps, investors are pricing at least one 25bp rate hike for the following year and interest rate expectations may gather pace over the medium-term as the central bank anticipates inflation to hold above the 2% target during the next 12 months. In turn, the BoE is widely expected to lift the benchmark interest rate off the record-low, and the central bank may look to unwind its emergency measures over the following year given the stickiness in price growth. However, as the new coalition in the U.K. takes extraordinary steps to balance the budget deficit, the tough austerity measures are likely to bear down on the recovery, and the central bank may face increased pressures to support the real economy as the fundamental outlook remains clouded with high uncertainty. As a result, we expect the BoE to maintain its current policy throughout the first-quarter of 2011, but the central bank may turn increasingly hawkish heading into the middle of the following year as ongoing slack within the private sector fails to temper the rise in inflation.

Nevertheless, the economic docket for the following week is expected to show mortgage approvals in Britain increase 46.5K in November after advancing 47.2K in the previous month, while manufacturing is anticipated to expand at a slower pace as market participants forecast the PMI to fall back to 57.4 in December from 58.0 in the month prior. As the private sector remains weak, with businesses scaling back on production, members of the MPC may struggle to meet on common ground given the substantial margin of slack within the real economy, and we are likely to see a growing split within the committee as they maintain their dual mandate to ensure price stability while fostering full-employment.