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Is Short Sterling a buy? 4th September 2008

04 September 2008

As the economy continues to slow, with Q2 GDP flat and house prices in a head long plunge, the Central Bank held policy because it remains concerned about inflation, and currently that concern eclipses fears over slowing growth.
The Bank of England expects inflation to spike to almost 5.0% short term, and even though they noted in the August quarterly inflation report that the down side risks to growth had intensified further, they still regard an economic slowdown as necessary to contain, then reverse inflation; back to target over the two year horizon.
But are they worrying too much about history rather than focusing on the future?
The main cause of global inflation, the oil price rally, has begun to correct and while it needs to fall further, it is undeniably well off the highs. If oil prices simply remained at current levels over the coming months, inflation would correct sharply lower.
But add to this:
the pinch consumers are feeling from utility price hikes which are unlikely to be reanytime soon, even if oil prices fall further,
the drop in house prices that will surely fall further, as Banks implement tighter lending standards, and
the weakening labour market
It is highly probable that inflation and the economy could plunge in the coming months. Indeed one MPC member, David Blanchflower, said as much recently when he commented that interest rates need to fall sharply.
So is the Bank of England likely to overcome is paralysis caused by inflation or is the economy on a one way ticket to oblivion?
We think interest rates will be cut and before year end. In our opinion the MPC will likely wait until they see Q3 GDP late in October; if this turns negative and oil prices remain at least around current levels, we think a rate cut could be possible in November.
The fact that this would also coincide with the November inflation report is in our judgement pure coincidence, but policy makers could use that occasion to explain their reasoning.
However we expect them to remain cautious with only a 25bp move, but that continued caution will mean policy will need to be reduced further during 2009.
So is Short Sterling a buy?
It could correct a little lower before the Bulls move back in, but our long term view is bullish.
Mark Sturdy
John Lewis
Seven Days Ahead

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