Moody's downgrade adds momentum to investor swing away from pound

Mon Feb 25, 2013 10:19am EST

* Sterling slides to 2-1/2 year low vs dollar after
downgrade
    * QE prospects help gilts recover from big initial fall
    * Markets see risk of further sterling and gilt weakness

    By David Milliken
    LONDON, Feb 25 (Reuters) - Britain's loss of its triple-A
credit rating from Moody's added to the pound's woes on Monday,
helping send it lower against both the dollar and euro, but UK
bonds, underpinned by the central bank, recovered quickly.
    The pound only fell moderately, but still hit lows against
the dollar not seen since July 2010. The euro rose
 against sterling to its highest since October 2011.
    Ten-year British bonds, or gilts, initially sold off sharply
but later regained most of their losses. British stocks were
broadly higher, lifted in many cases by prospects of greater
exports from a weaker currency.
    Moody's became the first major ratings agency to downgrade
British debt late on Friday, surprising some in the markets with
its timing, but reflecting a broad view that Britain will
struggle to meet its deficit-reduction goals due to weak growth.
 
    The impact was relatively muted because markets have already
been reacting to the conditions that prompted Moody's to act -
particularly an economy teetering on the brink of a third
recession in four years.
    The pound was under heavy selling pressure last week after
the Bank of England made clear that the currency could have
further to fall, and that it is prepared to tolerate the impact
this would have on inflation.
    Bank of England Governor Mervyn King's support for more bond
buying, or quantitative easing (QE), has also been undermining
sterling strength because it implies more potential money
printing.
    "Realistically this is not a sudden smash down but a
continuation of a move that's been under way all year," Andy
Chaytor, London-based macro strategist at Nomura, referring to
the reaction to the downgrade.
    "The stars have aligned in terms of fiscal policy, central
bank policy - being seen by the market to be allowing higher
inflation - and then you get a downgrade as well," he said.
     Sterling hit its two-and-a-half year low of $1.5073 during
Asian trading hours, and fell to its 16-month low against the
euro of 88.15 pence later.
     It is now around 7 percent weaker against both the dollar
and the euro than it was at the start of the year.
        
    GILTS RECOVER LOSSES
    In government debt markets, 10-year gilt yields 
jumped at the start of trading by 6 basis points to peak at
2.175 percent - their sharpest intraday price fall since Feb.
13. But later they were just 3 basis points up on the day at
2.14 percent and outperforming benchmark German Bunds
.
    The news last week that King and two other policymakers
favoured more bond purchases has lifted demand for gilts, even
if the inflation outlook weighs on them and some investors think
they offer poor value.
    "The (bank) minutes (last week) were pretty important
because they gave the market a life-line that more QE might be
coming," Chaytor said. "If we hadn't had that, things might have
been a bit rockier."
    Some investors said Chancellor of the Exchequer (finance
minister) George Osborne should not draw too much comfort from
the muted initial reaction in markets to the loss of a triple-A
debt rating he had repeatedly vowed he would protect.
    Toby Nangle, a fund manager at Threadneedle Investments,
said low gilt yields were driven by loose central bank policy,
and did not reflect any sense that Osborne's belt-tightening
drive meant Britain was in better shape than more heavily
indebted euro zone countries.
    "The government has favourably contrasted these low
government bond yields with high yields in a number of euro zone
countries that are as fiscally troubled as the UK. But this
comparison is without base and is disingenuous," he said.
    "Yields are low because the market believes that(interest)
rates will remain low, and because of the Bank of England's
policy of quantitative easing," he added.
    The next test of investor sentiment will come later this
week, and possibly as early as Tuesday, with a sale via
syndication of around 3.8 billion pounds of 2052 index-linked
gilts 

    * March gilt future 115.17 (-0.28)      
    * March short sterling 99.50 (UNCH)                 
    * June short sterling 99.51 (UNCH)    
    * 10-year yield 2.14 percent (+3 bps)    
                
--------------------- KEY MARKET DATA---------------------------
Long Gilt futures Gilt benchmark chain 
Short Stg futures Cash market quotes   
Deposit rates          Sterling cross rates 
UK debt speedguide 
--------------------KEY MARKET REPORTS--------------------------
Gilts                  Sterling             
Euro Debt          Dollar               
U.S. Treasuries        Debt reports         
-------------------- GILT STRIPS DATA --------------------------
Gilt strips data    All gilt strips 
Gilt strips IO    Gilt strips PO  
A list of all the strippable British gilts
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