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Thursday June 30, 2005 - 14:19:08 GMT

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Sterling sentiment deteriorates

There will be further concerns over the UK growth outlook, especially with evidence of a significant downturn in consumer spending. The Bank of England will be under strong pressure to cut interest rates and market expectations over a near-term rate cut will intensify with speculation that rates could be cut in July.

The Bank of England is likely to be cautious over a near-term response, especially as it needs to secure a controlled slowdown in the housing sector and will also be concerned over import costs. Recent data may also have over-stated consumer weakness. Sterling should also still be in a position to secure near-term protection from the Euro-zone weakness. US economic trends will be very important and Sterling will be vulnerable if US growth remains robust and the Fed continues to tighten. The most likely outcome, however, is that US growth will slow and the Fed will pause the tightening process during the third quarter. This would offer some relief to Sterling even though yield differentials are still likely to narrow.

Overall, Sterling is likely to be vulnerable to a further depreciation in trade-weighted terms as the economy deteriorates. The cyclical weaknesses in the Euro-zone and structural weaknesses in the US should prevent very heavy Sterling losses and allow a controlled depreciation. There is, however, a growing risk that Sterling will be seen as offering neither the security of the Euro-zone nor the levels of growth in the US and this could lead to substantial selling pressure. Sterling can also be vulnerable to big swings in sentiment and the overall risk profile will be higher, at least over the next few weeks.

Sterling under pressure

Sterling recovered from lows of 1.80 against the dollar early in June and strengthened back to near 1.84, but Sterling has weakened sharply again over the past week. The UK currency tested support at 1.80 and has now weakened below this level. Sterling has also weakened significantly on a trade-weighted basis and fallen to near 0.6730 against the Euro from recent highs around 0.6620. The immediate catalyst for Sterling weakness has been weak UK economic data and a shift in interest rate expectations.

Fears for UK economy

The latest figures on consumer spending have been disappointing and suggest a significant downturn. Although there was a small recovery in the monthly figures for May, the annual retail sales growth rate still slowed to the slowest rate for six years at below 2.0%. Consumer confidence indicators have weakened and there was a sharp drop in the CBI retail survey this week. The headline data was the weakest for close to 20 years and retailers were also pessimistic over July. Even if the data has been distorted, fears over a slowdown will continue

The latest evidence on house prices suggest that prices are static or falling slightly on a monthly basis while transactions have declined. The annual increase in prices has slowed to the lowest level for over five years and it may only be a reluctance to accept lower selling prices which is preventing a more significant decline in prices.

Employment levels are still strong enough to support the economy, but there will be concerns over debt levels. A sudden loss of confidence in the levels of debt could force a sudden retrenchment in borrowing and a downturn in consumer spending even if unemployment rises only slightly.

The industrial sector remains very weak with orders deteriorating again in June and the overall evidence suggests that growth in the economy is slowing. First-quarter 2005 GDP growth estimates were revised down, although estimates for 2002 and 2003 were revised up.

The weak data has reinforced market expectations over a near-term cut in UK interest rates. Futures markets are now looking for a rate cut as early as July and are close to pricing-in two rate cuts by the end of 2005.

Wariness over inflation

The annual inflation rate was unchanged at 1.9% in May, just below the 2.0% Bank of England target. Earnings growth is under control, but the bank will still have some concerns over the inflation outlook. The renewed increase in oil prices will put upward pressure on prices and the UK currency has also weakened against the dollar which will increase the risk of rising imported inflation. Bank of England Governor King has also warned that rising import prices are a concern.

Sterling’s decline against the dollar from levels above 1.90 early in the second quarter will also increase the risk of imported inflation.

US rates still rising

The US Federal Reserve will continue to increase interest rates in the short term with an almost-certain increase to 3.25% this week from 3.0%. The Fed is also likely to consider a further increase in August, but there is a good chance that the Fed will then decide on a pause in the tightening process. If so, there will be a reduced risk that Sterling’s yield advantage will disappear. The most likely outcome is that there will be a positive interest rate differential of around 0.75% by the end of 2005 from 1.75% now, although there is a small possibility that the gap will close completely.

Fundamental doubts.

The trade position has shown some signs of stabilising, but the monthly deficit is still running at levels close to GBP5.0bn on a monthly basis and this will leave Sterling vulnerable to some selling pressure.

The UK external deficits are not as bad as the US, but there will be the risk that Sterling will be put in the same camp as high current account deficit economies such as the US and Australia if there is renewed market fears over the trade and current account positions. The May budget figures were also weaker than expected, increasing the risk that the UK currency will be vulnerable to selling pressure on fears over twin deficits.

There will be the possibility that Sterling will be seen as having the disadvantages of the US deficits without the advantages of strong growth. There will also be increasing fears over stagflation if the current run of poor data continues and this would damage international confidence.

Sterling will continue to gain some support from the lack of confidence in the Euro-zone economy, especially with the ECB also under pressure to cut interest rates. Sterling’s position will also be stronger if the US economy deteriorates.


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