Fundamental Forecast for British Pound: Neutral

Relative yield spreads have taken the top spot as the driver of British pound price action with GBPUSD showing an increasingly firm correlation with the spread between the return on UK and US 5-year Treasuries. Looking at the week ahead, this puts the onus squarely on the monetary policy announcement from the Bank of England.

Needless to say, markets are pricing in no changes in benchmark borrowing costs, with the real issue being the size of the fate of the central bank’s asset purchases. Inflation remains stubbornly high, with CPI adding 3.3 percent in the year to November to show the fastest price growth in six months. While this seems to argue against an expansion of quantitative easing, the landscape could change dramatically as the more painful elements of the government’s austerity program kick in this month.

On balance, Mervyn King and company are likely to delay any policy adjustments at least until February when they can be underpinned by updated quarterly inflation report. With that said, markets will be keen to get guidance on what the central bank needs to see to move policy out of neutral toward some sort of directional bias, whether hawkish or dovish. Should the BOE opt to remain mum following the rate decision, the spotlight will shift to the release of minutes from the meeting due two weeks after the announcement itself.

Naturally, the other half of the yield spread equation is what happens with US yields, where a pullback in the wake of Friday’s disappointing employment figures. While this may give GBPUSD a bit of a boost, the correction is unlikely to upset the emerging uptrend in Federal Reserve rate hike expectations that began taking shape in early November of last year, hinting gains are likely to be short-lived.

Finally, the Euro Zone debt crisis may prove to be a significant catalyst. Periphery credit-default swap spreads (the cost of insuring against a sovereign default) soared last week following a flare-up in Belgium as well as unease ahead of next week’s bond auctions from Portugal, Spain and Italy. Should these see a disappointing uptake, sterling may find support as capital flees from Euro-denominated assets to seek shelter in the UK currency as an alternative medium of exchange.

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