Sterling Downside Risks Second Half of the Week

The British pound remains among the better performing currencies in the wake of the dollar's recovery that began in the second half of last week. Underpinning it are ideas that the BOE may very well be the first of the major central banks to hike rates. In fact, various market based measures suggest the risk is about 1 in 5 that a hike takes place this week. Subjectively, we suspect the odds are half of this at best.

It is true that the shadow MPC at the IEA favored an immediate hike and that at the last MPC meeting, two members favored a hike. However, the economic data is sufficiently mixed and there is still a reasonable argument to be made over the transitory nature of the price pressures, insofar as there is no real pressure coming from wages, that the BOE will leave rates on hold Thursday.

That said, BOE Governor King has been out-voted before, and could again. But, there has been so suggestion by other MPC members that there has been a significant shift in their views.

The market though continues to take UK rates higher. The short-sterling futures still is implying 3-7 bp higher rates today. For example, with today's losses, the June short-sterling futures contract implies the highest yield since last July (~1.2%). To put this in perspective, after the UK reported an unexpected (0.5%) contraction in Q4 10 GDP, the June short-sterling futures implied a yield just below 90 bp.

The rise in UK rates is not limited to the money market rates. The 2 year yield jumped 5 bp today and is up nearly 100 bp since late Oct and 50 bp since the start of the year. A big shift took place in the UK's favor over the euro zone last week and there is follow through today. In the past five sessions alone, the UK-German 2-year spread has widened 26 bp of which 11 bp is taking place today. This also appears to be lending sterling support against the euro. In fact the euro is breaking below GBP0.8400 now for the first time in a couple of week's. Potential exists toward GBP0.8330-40.

At the same time, the speculative community appears to have built a substantial long sterling position. At the IMM, net speculative sterling longs jumped from 7.8k contracts to 22.6k in the week ending Feb 1. This is a relatively large position at the IMM and is among the largest net long position since Q1 08. These late longs look vulnerable to us and increasingly so from midweek on. Position squaring ahead of the BOE meeting and then further position adjustment afterward seems to be the most likely scenario. Of course what MPC members say is important, but unlike other central banks, like the Fed and ECB, when the BOE doesn't do anything, it doesn't say anything.

Next week, the UK reports Jan CPI data and it is likely to rise again as the VAT hike gets implemented and there have been higher energy and food prices. However, the quarterly inflation report on Feb 16th would potentially be a venue for the BOE to begin to prepare the market. At the same time, February data will be important after the weather distortions of Dec and Jan.

Sterling could rally another cent to so toward last week's high near $1.6280 ahead of the BOE meeting, from where we would anticipate it to come off.