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Trading Short Sterling: it’s only a pullback!

14 February 2008

The Macro Trader’s view:
After making a recent high late last week, Short Sterling and indeed Euribor too, have been trading lower all week.

That’s because the hysteria of the Fed’s recent 125bp rate cut which led traders to believe similar moves could be necessary here, has given way to a sense of realism and a reappraisal of where UK interest rates may eventually go to this year.

But we think the recent correction is excessive. December 08 Short Sterling is giving up expectations of a full 25bp rate cut and looks as though it could correct further short term, especially as a result of yesterday’s release of the Bank of England’s quarterly inflation report.

Mervin King played down the prospects for future UK interest rate cuts, leaving commentators with the impression that maybe only two more rate cuts are likely this year. His reasoning was that inflation is expected to push up to around 3.0% over the short term, mainly due to food and energy price increases.

However, the inflation report also forecast growth to slow more sharply than previously thought and two quarters of -0.1% growth (a technical recession) seemed to him as quite likely.

Additionally, the report also noted that house price inflation could turn mildly negative in real terms with negative implications for consumer demand, but still the Governor thought aggressive rate cuts wouldn’t be necessary and the period of slower growth almost welcome.
Here we part company with policy-makers. If the UK housing market begins to correct, it is unrealistic to think the correction will be either mild or of small consequence. Were such a correction to begin, prices could fall as much as 10-15% or more with house repossessions rising as lenders quickly tried to limit their downside risk after the losses already incurred by the credit crunch.

Clearly though this would only aggravate credit conditions and wound financial institutions further, with a bigger hit to growth likely. The Bank alludes to this and calls it an “adverse feedback loop”. Call it what you will, but we judge the MPC would need to cut more aggressively under such circumstances; indeed their rather relaxed and unrealistic assessment of the risks almost ensures the scenario will materialise, and it seems they have learned little from their mistakes during the summer when they completely miss-judged the severity of the wholesale money market liquidity squeeze.

We judge the period of slower growth, which is a phenomenon affecting the developed economies, will reduce demand for oil and result in lower oil prices. Since inflation in the western economies was driven by the long rally in the oil market, a correction there would alleviate and reverse the problem.

If the Bank of England is serious in its thought that maybe two more cuts are all they can manage, the UK economy will be in big trouble, but by then it will be too late to avoid a recession as the MPC will be way behind the curve.

We still see interest rates in the UK falling by a further 1.0% this year and although we think the current correction could go further, it will provide an excellent buying opportunity.

The same holds true for Euribor which is being dragged lower by negative sentiment from the UK, but will likely not suffer such a deep correction as rates are yet to ease in Europe.

The ECB have already signalled a change of policy stance and belatedly recognise the risks, we see a rate cut in the Euro zone possibly in April, so as with Short Sterling the current sell off is a buying opportunity and as ever timing will prove crucial.

The Technical Trader’s view:

Weekly Bar Chart

The market is well-set. And we have been profitably bullish (until the end of last week) in our Key Trades Portfolio.

That’s because there are two nested Head and Shoulders Patterns driving the market better in the medium-term.

The minimum target of both those patterns is a good deal higher.

There is, however, the consideration of the old Highs – a Pivotal level at 96.52 and 96.61.

Note well that the market has failed to get through them at the first attempt.

Look closer.

Daily Chart:
The detail shows how the price action looks decidedly tired.

We will be watching carefully how the market behaves firstly at the diagonal and then below there at the support from the 95.18 High.

A break of those support would suggest a return to the Long run neckline support - but we doubt that will happen.

Mark Sturdy
John Lewis
Seven Days Ahead

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