UK rate cut would hurt pound more than QE

by on July 30, 2012 2:19 pm BST

Mon Jul 30, 2012 10:19am EDT

* BoE rate cut could impact sterling more than QE

* UK rates at 0.5 pct now attractive after ECB rate cut

* Weak economy poses credit rating risk, dims pound’s appeal

By Jessica Mortimer

LONDON, July 30 (Reuters) – Sterling has held up well
despite the Bank of England printing vast sums of money to aid a
fragile economy, buoyed by a rush for alternatives to an ailing
euro, but a cut in already record low interest rates could
tarnish its allure.

Under normal market conditions, monetary easing is seen as
negative for a currency as it increases the supply of money in
the system, potentially fuelling inflation that erodes an
investor’s returns.

But a deepening euro zone debt crisis has focused investors’
minds on preserving the value of their capital in what they view
as safe assets. This has kept sterling strong, especially versus
the euro, despite the BoE printing money.

However, a Bank of England rate cut, coming in the wake of
this month’s cut in European Central Bank rates, would eat away
at sterling’s yield advantage over other major currencies — one
factor making it an attractive investment.

This, analysts say, would slow sterling’s gains against the
euro and push it lower against other currencies.

A cut in coming months would come as concern grows about a
deepening recession that could hamper efforts to cut the UK’s
deficit and put its prized top credit rating at risk.

“The UK has benefited from being a bit of a safe haven from
Europe. That could change if we start to see a further
deterioration in the UK and particularly if we start to see
(downward) pressure on rates as well,” said Ian Stannard,
currency strategist at Morgan Stanley.

Since taking benchmark rates to a record low 0.5 percent in
March 2009, the BoE has focused on pumping more money into the
system via its bond-buying programme, arguing another rate cut
would only have marginal benefits and may damage banks’ margins.

But BoE policymakers, who have long welcomed sterling
weakness to revive exports, may rethink their stance, especially
after the ECB on July 5 lowered the rate at which banks park
excess funds with it to zero.

This hit the euro hard as many investors were left with no
reason for holding it. Its losses accelerated, taking it to a
near four-year low of 77.56 pence against the pound.

In an environment where all major central banks have
ultra-low interest rates, even the UK’s paltry 0.5 percent can
look attractive. The U.S. Federal Reserve targets a rate between
zero and 0.25 percent while rates in Japan stand at 0.1 percent.

“It’s a lot more worthwhile if you put your money in
something that gives you a couple of basis points than something
where you have to pay to put money in,” said Dagmar Dvorak,
director of fixed income and currency at Barings Asset
Management, which has $47 billion under management.


The chances of a rate cut have risen since data showed the
economy slid deeper into recession in the second quarter. And
minutes to July’s BoE meeting showed policymakers may reconsider
reducing rates, though they said this would not happen for
several months.

“If there was a 25 basis point cut in the (BoE) bank rate I
could see euro/sterling trading back above 80 on that,” said
Chris Turner, head of currency strategy at ING.

The euro traded on Monday at about 78 pence.