Fear has boosted GBP relief should weaken it

Fear has boosted GBP relief should weaken it

 GBP has performed somewhat better over the last few
months than we anticipated. Our assumption was that
GBP TWI would remain range-bound, reflecting the
countervailing forces of domestic economic weakness
and continued debt monetization from the Bank of
England on the one hand versus euro stress and safehaven
inflows into the UK on the other. As it turned out,
the safety aspect of GBP proved more significant and
EURGBP declined by a few percent more than forecast.
Overseas investors bought a record volume of Gilts in the
latter part of 2011 (nearly £40bn – chart 1), encouraged
not only by the deterioration in the euro zone crisis but
also by the absolute safety net provided by the BoE’s
extension to its Gilt purchase programme. The result is
that GBP’s correlation to risky markets has turned
negative in recent months. Only the US dollar has had a
more negative correlation (chart 2).

 Having benefitted from safe-haven demand it is natural
to expect sterling to underperform should the negative
tail-risk in the Euro area continue to recede. EUR/GBP is
amongst the most undervalued of the euro crosses and we
see decent potential for the cross to rebound towards 0.85
in the next month should the euro risk premium continue
to subside. Cable should hence underperform in any
further EUR/USD rally, although once the initial
adjustment in EUR/GBP is complete we would expect to
see correlation between GBP/USD and EUR/USD
increase. The euro crisis has resulted in a partial
decoupling of these two, depressing the beta to
historically low levels (chart 3). Less euro stress should
mean a closer relationship between cable and EUR/USD
going forward.

 There are few immediate ramifications for sterling from
the prospect that Scotland will hold a referendum on
independence from the rest of the UK, 1) The referendum
is only likely to be held in 2014; 2) Support for full
independence is currently running at only 30%; 3)
Scotland accounts for 8% of UK GDP. The steady-state
economic impact of independence on the remainder of
the UK would not be substantial. That being said, a vote
for independence would create substantial uncertainty
regarding the distribution of UK assets and liabilities
(including public debt) between the countries, not to
mention currency arrangements (it is not clear how a
fiscally independent Scotland could continue to use
sterling and accept English interest rates). One by-byproduct
of Scottish independence would be to shift
potential electoral outcomes in the remaining UK
Parliament to the right, given that Scotland has returned
few Conservative MPs in recent years. Removing
Scottish MPs from the current Parliament would result in
an outright majority for the Conservatives of 19 seats
compared to the current shortfall of 38 seats).

JP Morgan Forecasts GBP

GBP Potential trigger events

 Despite holding critical support at this month’s low, the
bigger picture view for Cable maintains a negative bias.
However, the reversal from the medium term range lows
near 1.52/1.53 confirms a short term corrective phase is
underway. Importantly, this zone includes the Sept’10
and Oct’11 lows, as well as the 61.8% retracement of the
rally from the May ’10 cycle low and should continue to
define whether a deeper downside corrective phase can
develop.

 The key initial upside test enters at the 1.5660
downtrendline from the August ’11 peak. Still, the
1.5780/1.5800 area which includes the late-
November/December range highs presents a more
important test for this retracement. A break of these
levels is likely to be a difficult task and where we sense
Cable is vulnerable to a bearish reversal. Violations of
the 1.52/1.53 support zone should allow for a decline into
the 1.4823, 76.4% retracement of the advance from the
2010 low with an increased risk that prices can extend
into the 1.4228 low.