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

LONDON (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.

Rush hour workers pass St Paul's Cathedral as they cross London Bridge in London January 29, 2013. REUTERS/Luke Macgregor

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.


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 February 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 favored 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 favorably 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

Additional reporting by Li-mei Hoang, Sinead Cruise and Anirban Nag. Editing by Jeremy Gaunt.