Sterling's sell-off against the dollar and yen this month has undermined its "safe-haven" appeal, and the prospect that a struggling economy may soon require more monetary stimulus could knock the UK currency sharply lower by year-end.
--- Sterling's 'safe-haven' appeal tarnished in September sell-off
--- Possibility of more UK quantitative easing to press pound lower
--- Sterling poised to track lower UK gilt yields
Growing expectations of Greek debt default and of cooling global growth triggered a sell-off in the euro and other currencies seen as higher risk this month. The pound was caught up in the selling and is on track for its worst monthly performance versus the dollar since May 2010.
"The liquidation move out of risk and the dollar's rally in the past few weeks has given the catalyst for sterling to move out of its $1.60-1.65 range and into a lower trajectory," said Chris Walker, currency strategist at UBS. "Sterling is now trading with rates again and in that sense it has potential to go lower," he said, adding the pound could fall as low as $1.45 before the year is out.
Many short and longer-dated UK gilt yields hit record lows this month as broad risk aversion has boosted triple-A bonds, but the gilt rally has also been driven by speculation the Bank of England may start purchasing government debt. The BoE cut rates to a record low 0.5 percent in March 2010 and is not seen raising them until 2013, in stark contrast with expectations earlier this year they would be at 2 percent by the end of 2012.
But investors ploughed into the unmatched liquidity of the dollar this month due to escalating worries Greece may be unable to avoid default. As a result, sterling has been bumped out of its well-worn $1.60-1.65 trading range and into $1.55-$1.60 territory.
As sterling's allure as a "safe" currency crumbles, the UK faces the possibility the BoE may soon pump billions of pounds into the markets to buy UK assets to stimulate the economy, putting the currency under more downward pressure. A Reuters poll of economists shows a 75 percent chance the BoE will adopt further quantitative easing and a 40 percent chance it will happen next week.
The bank's policymakers meet as the ruling Conservative party concludes its annual conference. The coalition it dominates has insisted it will stick with its austerity programme.
GILT LINK Sterling had held to its range through early September even as gilt yields turned lower earlier this year due to flight-to-safety demand and the prospect of more easing. The tight correlation between trade-weighted sterling and 20-year gilt yields - the maturity seen benefiting the most from any renewed programme of quantitative easing - through May has loosened in past months as investors have priced out interest rate rise expectations. But this correlation could tighten again as the pound starts to weaken in tandem with yield, just as it did when the BoE launched its 200 billion pound gilt-buying plan in March 2009.
This suggests speculation about easier policy might be a key driver of a lower sterling and lower gilt yields, rather than flight-to-safety flows. Were the latter the case, increased demand for gilts would be accompanied by a rise in sterling.
The latest Reuters asset allocation poll shows risk aversion boosted demand for UK bonds this month, after a big fall in August. But while US investors increased their share of UK debt, domestic buying was mainly responsible for much of the shift in September, largely wiping out any currency impact.
Another sign the safe-haven argument for sterling is dwindling is its sharp fall versus the yen, which along with the dollar is considered among the most secure currencies. Some analysts say sterling could weaken further if QE fails to boost anaemic growth and piles pressure on the government to delay some of its austerity measures, a move that may threaten its triple-A rating. "We're hearing a lot of debate about whether we should reconsider fiscal policy. If that was the case, the market would become concerned about the prospect of a UK ratings cut," said Audrey Childe-Freeman, FX strategist at J.P. Morgan Private Bank.
"From that perspective, sterling is in a no-win situation." Even versus the suffering euro, the pound could stay under pressure, as analysts are optimistic European officials will take proactive steps to solve its debt crisis. This would boost the euro from around 86.50 pence at the moment.