Moody's downgrade adds to investor swing away from pound

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By David Milliken | February 26, 2013 6:00 AM EST

Britain's loss of its top credit ranking from Moody's added to the pound's weakness on Monday, helping send it lower against both the dollar and euro, but UK bonds, underpinned by the central bank, recovered quickly.

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, known as gilts, initially sold off sharply but later closed flat, attracting interest from investors worried about the outcome of Italy's elections. British shares were broadly higher, lifted in many cases by prospects of stronger 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 a weak economy will impede British efforts to reduce its deficits.

Nonetheless, the move was an embarrassment for Chancellor George Osborne, who promised in the past to protect Britain's AAA credit rating.

"The credit rating is an important benchmark for any country but this government's economic policy is tested day in and day out in the market, and it has not been found wanting today," Osborne told parliament.

The main spokesman for finance in the opposition Labour Party, Ed Balls, told Osborne to "get out of denial and get a new plan that will actually work on growth, jobs and the deficit. Or else the prime minister will have to get a new chancellor."

Earlier, a spokesman for Prime Minister David Cameron echoed Osborne's comments that the government would stick to its plan to cut the budget deficit and public debt.

The impact of the downgrade was relatively muted in markets because investors 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 came 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's Governor Mervyn King's support for more bond buying, or quantitative easing (QE), has also weighed on sterling because it implies more potential money printing.

"Realistically this is not a sudden smash down but a continuation of a (market) move that's been under way all year," Andy Chaytor, London-based macro strategist at Nomura.

"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, before recovering to $1.515. It fell to a 16-month low against the euro of 88.15 pence and then recovered as uncertainty about the Italian elections weighed on the euro.

The pound was around 7 percent weaker against both the dollar and the euro than it was at the start of the year.

GILTS RECOVER LOSSES

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. Later they ended the session flat at 2.11 percent.

News last week that King and two other policymakers favoured more bond purchases has helped gilts, even if the inflation outlook makes some investors think they offer poor value.

Last week's central bank minutes "gave the market a life-line," Chaytor said. "If we hadn't had that, things might have been a bit rockier."

Some investors said Osborne should not draw too much comfort from the muted initial reaction in markets.

"The government has favourably contrasted (Britain's) low government bond yields with high yields in a number of euro zone countries ... But this comparison is disingenuous," said Toby Nangle, a fund manager at Threadneedle Investments.

"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 ($5.7 billion) of 2052 index-linked gilts

(Additional reporting by Li-mei Hoang, Sinead Cruise and Anirban Nag and William Schomberg; Editing by Ruth Pitchford)

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