Fundamental Forecast for British Pound: Neutral

As we discussed in our fundamental trends monitor, monetary policy expectations remain a key driver for the British Pound with GBPUSD continuing to show significant correlations to UK – US 2-year and 5-year yield spreads. However, the landscape is complicated by the reemergence of a significant link to broad-based risk sentiment as evidenced by a resurgent positive relationship between the currency pair and the MSCI World Stock Index, opening the door for a volatile week ahead.

On the monetary policy front, the spotlight falls on the Bank of England as it publishes minutes from January’s MPC meeting. The dramatic build in priced-in rate hike expectations for coming year (as tracked by Credit Suisse) suggests traders see the central bank as likely to err on the side of price stability, stepping off the sidelines to tighten lending conditions as inflation continues to push higher despite the threat that such action would pose to the nascent economic recovery, particularly as the more painful elements of the government’s austerity program kick in.

Indeed, the central bank argued throughout 2010 that inflationary pressure was temporary and would subside over the medium term without tightening. Clearly, this has proven to be wrong, suggesting that putting off the issue for much longer threatens to become a credibility problem for the monetary authority. A relatively robust fourth-quarter GDP reading will only add to the anticipation, with the annual growth rate set to print above its long-run average despite a shallow downtick from the preceding period. With that in mind, traders will be keen to parse the meeting minutes for any clues on policymakers’ thinking ahead of February’s MPC sit-down, an event made all the more important considering it coincides with the creation of an updated quarterly inflation forecast.

On the sentiment side of the equation, all eyes will be focused on a busy US economic calendar, with the Federal Reserve monetary policy announcement and the preliminary fourth-quarter GDP report in focus. For the former, traders will be most concerned with quantifying policymakers’ “threshold” for reducing or even suspending the second round of quantitative easing before its scheduled completion after hints at the existence of such a barrier suddenly emerged in Fed officials’ comments over recent weeks. Meanwhile, the top question for the GDP report will be whether an aggressive pickup in growth is interpreted along fundamental or risk-driven considerations, with the former being Dollar-positive while the latter being likely to weigh on the safety-linked US currency.

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