GBPEUR/GBPUSD

The Pound declined for a second successive day against the Dollar, falling back towards $1.63 in London, while the UK currency also dropped for the first time in five days versus the Euro, amid speculation that further quantitative easing may weaken the UK's financial institutions. The Bank of England's monetary policy committee will announce on Thursday 5th November whether or not they will extend the current asset purchasing program.

The Central Bank may choose to risk doing too much, rather than too little this week, as the UK economy begins to fall behind the rest of the world in terms of economic recovery. Germany and France have both exited the recession, while the latest third quarter growth estimates in the U.S showed that the world's largest economy also returned to growth in the three months through September.

In stark contrast, a report from the Office of National Statistics on October 23rd showed that the UK economy unexpectedly contracted 0.4% in the third quarter, to signal the worst and most prolonged recession ever recorded. As a result, the Governor Mervyn King and the nine member MPC will probably expand its bond purchase program by a further £50 billion to £225 billion.

An increase on Thursday would be the third time since the program started in March but policy makers are adamant that the unprecedented action to purchase government bonds with newly created money is starting to work. Officials are juggling the danger that too much spending will weaken the Pound significantly and stoke another housing boom against the risk that too timid an approach will prolong the worst slump since the Second World War.

Stewart Robertson, an economist at Aviva Investors, said that "the danger is you over-stimulate the economy, asset bubbles being the main risk as well as the Pound. But if you wait to see the impact, it's always too late." The Bank of England will also keep the benchmark interest rate unchanged at a record low of 0.5%.

The Pound has dropped 6% in value against a basket of currencies since August, despite a host of economic reports signaling that the UK economy is through the worst of the slump. The bond purchasing plan has already split the Bank of England's board once this year, when Mervyn King pushed for an increase to £200 billion in August and was rejected by six votes.

King maintained that the consequences of less stimulus "might be less severe than the possible costs of acting too cautiously". Chief economist Spencer Dale argues that a smaller increase was warranted because of the risk the program may stoke asset prices too much. Economic data since then has given justifications on both side but the third quarter growth estimates came as a big surprise, while industrial production unexpectedly slumped in August to the lowest level since 1992.

The FTSE 100 Index has gained about 10% since the Bank of England last increased bond purchases, taking its gains since its March trough to 40%. A Hometrack Ltd report last week showed that house prices increased for a third month in October, while manufacturing activity expanded at the fastest pace in two years.

A gauge based on a survey of companies rose to a reading above 53.7 in October, from 49.9 the previous month, a sign that factory production is recovering from the longest downturn on record. Yesterday's report will add to the drama of Thursday's announcement and make the decision a little tougher for officials, as they gauge whether the economy needs additional stimulus.

Other Central Banks around the world are indicating that it is time to withdraw some of the emergency measures introduced to stave off another Great Depression. Australia and Norway have already raised interest rates and ECB governing council member Axel Weber has said that the Central Bank may withdraw unlimited 12-month loans next year.

The UK economy is slower to emerge from the recession and additional quantitative easing may hurt the Pound, which has dropped 5% against the Euro since the August decision. Nick Kounis, chief European economist at Fortis Bank, said that "if others have tightening stances and the Bank of England is going full steam ahead with easing, that could put further downward pressure on the currency."

Euro and Dollar buyers may wish to take advantage of the current rate or at least place a stop order prior to the BoE rate announcement on Thursday, in case additional stimulus measures undermines the UK currency. However, some economists believe that the third quarter growth figures were so unexpected that the BoE may be reluctant to increase quantitative easing on the back of that report.

Former policy makers Charles Goodhart and DeAnne Julius said that the contraction in the third quarter shouldn't overshadow other signs that the economy is improving. Charles Duma, chairman of Lombard Street Research, also said that "the third quarter flash estimate puts the Bank of England on the spot in no uncertain fashion. But they'll want to do as little as possible, given the extraordinary uncertainties."

The Pound declined against all of the 16-most actively traded currencies yesterday, after Royal Bank of Scotland Plc, which received a government bailout last year, said it may need to sell more assets than planned to satisfy the European Union. Share prices subsequently dropped as much as 14% and the Pound is falling due to more concerns over the state of the financial sector.

The Pound slumped 0.5% to $1.6369, dropping 1.1% over the past two trading sessions. Neil Jones, head of European Hedge Fund sales at Mizuho Corporate Bank Ltd, said that "the strong correlation between the UK financial system and the Pound continues. Future prosperity of the UK economy is heavily dependent."

EUR/USD

The Dollar declined against the Euro yesterday, as we build up to this week's Federal Reserve meeting, with economic reports showing expansion in U.S housing and manufacturing sectors. Factory production in the U.S expanded in October at the fastest pace in more than three years, a sign that factories will be the main drivers of the economic revival.

The ISM index rose to a reading of 55.7, exceeding the most optimistic economist's forecast, from 52.6 in September, the second consecutive month of growth. Rising sales, boosted by the "cash-for-clunkers" program, have led to a record plunge in stockpiles that will keep assembly lines busy. More than $2 trillion in global stimulus will also boost demand but rising unemployment will impact on consumer spending.

The positive tone of the report increased risk appetite, as investors moved away from lower-yielding currencies, and the Dollar slumped 0.7% versus the Euro to $1.4843 in New York. The Euro may rise to $1.4860 this week, amid signs of an economic recovery will continue to gather momentum and reduce the appeal of the Dollar as a haven.

Data Released 3rd November

EU EC Autumn Macro Economic Forecast

U.S 15:00 Factory Orders (September)

written by Adam Solomon

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