Sterling gains vs euro reflect debt crisis not veto

LONDON: The euro's fall against sterling reflects investor anxiety about the euro zone crisis rather than British Prime Minister David Cameron's decision to stay out of proposed changes to a European Union treaty.

The euro fell to a nine-month low of 84.165 pence on Tuesday, its lowest since late February, and analysts expect more gains for sterling in coming weeks as investors choose the safety of UK government bonds over euro zone assets.

But sterling has gained less against the euro this week than the dollar. Analysts said the pound's gains were not driven by any improved perception of the UK, but rather by the euro zone's debt troubles.

"Despite all the anti-UK news that has been generated from Cameron's decision to veto, markets have voted against the EU and sterling has gained against the euro," said Stuart Frost, who oversees $50 million in a currency fund for RWC Partners.

In the longer run, investors worry Cameron's veto of a proposed treaty to tighten fiscal control could affect Britain's

strong trade links to the euro zone.

Last week's summit agreement fell short of any commitment to common euro bonds or measures that would see the European Central Bank step up purchases of bonds in the secondary market, keeping the crisis at the forefront of investor concerns.

Cameron used his veto against full treaty changes after EU leaders rejected his pleas for the UK to opt out of EU-wide banking regulation and on concerns over a potential transaction tax that could hurt the London as a financial centre.

Analysts said that while this decision could hurt trade and the UK's bargaining power within the EU, in the near term the fact that UK has a plan to reduce debt that markets see as credible and a central bank acting as a lender of last resort was shoring up confidence in sterling assets.

"We have been long sterling and short euro and while this has been a slow and cumbersome trade, we expect it to fall to 80-81 pence in the next three months," said RWC Capital's Frost.

Chris Walker, a currency strategist at UBS said UK gilts would remain a "port in the storm" from Europe and that this could see the euro trade with a weak bias against sterling.

Gilts have been among the best performing sovereign bonds, with 10-year yields falling to record lows on Tuesday. They outperformed German Bunds, with the yield differential tightening by 3 basis points, reflecting robust demand for gilts. Foreigners bought about 12 billion pounds of gilts in September, the most since April 2010.

LONGER TERM UNCERTAINTY

Lee Hardman, currency economist at Bank of Tokyo Mitsubishi UFJ, said the pound and gilts were benefiting from the Bank of England's asset purchase programme which sets it on course to hold around 30-40 percent of outstanding debt.

"In the long run, the risk of higher inflation in the UK may eventually prove pound-negative but in the near term having the central bank stand behind the domestic debt market is providing a source of stability," he said.

His bank expects the euro to fall to 82 cents in six months and to 80 pence in 12 months.

Audrey Childe-Freeman, EMEA head of currency strategy at JPMorgan Private Bank, said the UK's isolation over the proposed treaty was not a huge problem in the short run.

"It is probably positive in the short term because the market doesn't trust the euro zone and being as far away as possible from those issues is good," she said. "If the euro eventually gets out of its current predicament, then being isolated would be negative for the UK."

Sterling is also likely to struggle against the dollar as the prospects of more quantitative easing by the Bank of England weigh along with the country's links and banking sector's exposure to the euro zone.

Almost 50 percent of UK's exports are to the euro zone and UK banks holdings in Greece, Portugal, Italy, Spain and Ireland amount to more than 15 percent of UK's GDP.

All of which is likely to drive investors to seek the relative safety of the dollar if the euro zone crisis worsens. Sterling traded at $1.5540 on Tuesday, almost flat on the year.

"US data is showing signs of improving while people will be worried about UK's exposure to the euro zone," RWC Capital's Frost said. "Some are expecting it to fall to $1.51."