Sterling outlook - UK Triple A rating to go next year

Given the lack of growth over the past 12 months the pound has had a pretty good year given the problems facing the UK economy. If it hadn't been for the Olympic Games and Diamond Jubilee then things could well have been a lot worse for the UK in terms of economic activity.

The risks to the UK's triple "A" rating never really materialised and the fact that the Chancellor hit his borrowing target for 2011/12 also helped in that regard.

It would appear though the Q3 growth figure of 1% will prove to be the exception with a strong possibility that Q4 will show a negative growth figure to go with Q1 and Q2, given the recent poor readings on PMI data as well as poor manufacturing and industrial production data seen so far in Q4.

The December Autumn Statement by the Chancellor has laid bare the problems facing the UK economy as tax revenues fall back sharply against a backdrop of falling incomes, consumer confidence and rising prices, and accounts for the recent decision by S&P to drop into line with Fitch and Moody's and put the UK's triple "A" credit rating on a negative outlook for a downgrade.

Retail sales and the services sector this calendar year have proved remarkably resilient, helping to stop the UK economy from contracting sharply. Retail sales this calendar year so far have grown 1% which given the current climate of high inflation and squeezed incomes remains remarkable. It seems unlikely, given the continued squeeze on incomes, that 2013 retail sales will be anywhere near as good.

Twelve months ago the main concerns occupying the Bank of England MPC was inflation with a continued insistence that it would fall back and 12 months on nothing much has changed with inflation remaining sticky, while markets speculate about the likelihood of further asset purchases. Given that inflation remains high and will likely continue to be so the Bank of England's room for manoeuvre on further asset purchases remains very limited. This has sent UK gilt yields up to six month highs near 2%. If we break above 2% we could well see a sharp move to 2.20% quite quickly.

For this fiscal year it seems likely that the Chancellor will struggle to meet his self-imposed borrowing target due to the falls in tax revenues and the lack of growth, which was expected to be around 1%, twelve months ago, but now is likely to be in the region of -0.1%.

This month's decision by the Chancellor to extend the period for balancing the budget has, not surprisingly raised expectations that the UK's prized triple "A" rating could well disappear in 2013.

French owned ratings agency Fitch, which currently has the UK on a negative outlook articulated its concerns about the fiscal slippage, and said that it would review the UK's rating after the March budget.

Neither Moody's or Standard and Poor's have made any comment so far but given they also have the UK on negative outlook, the odds of a move on the rating remain high.

Fortunately for the Chancellor the risks of losing the rating are a lot less than they were in 2010 when borrowing costs were much higher and UK gilt yields were around the 4% level. The problem the Chancellor has with respect to that is more political than economic, given his insistence on protecting it no matter what.

Since then the situation in Europe has deteriorated to such an extent that all the triple "A" countries in Europe are also on negative outlook's with the exception of Finland which has a stable outlook.

France has lost its triple "A" rating with Moody's and Standard and Poor's and given Germany's increasing exposure to European bailouts it can only be a matter of time before Europe's growth engine loses its rating as well, though probably not before the UK loses its rating.

It therefore comes down to when the UK rating gets cut and not "if", though the likelihood is that when it happens the reaction could well be muted given that Germany may well be not too far behind, due to the increasing costs of bailing out Europe.

A ratings cut therefore may not be as sterling negative as feared given the performance of the pound over the past 12 months.

Against the US dollar and the euro the pound has made gains largely as a result of the Fed's ultra-loose monetary policy and safe haven flows out of Europe.

Cable

The outlook for cable is likely to be more of the same in 2013 with a range of 1.5300/1.6500, similar to this year while the expectation is for further sterling gains against the single currency, even allowing for the short term stabilisation brought about by the ECB's OMT program.

Resistance in GBP/USD can be found at 1.6310, a break of which could well target the 2011 highs at 1.6750. Support comes in at the 200 day MA at 1.5870 and trend line support from the 1.5270 lows at 1.5900.

EURGBP

The recent rally in the euro against the pound is currently running up against resistance at 0.8175, while the recent crossing of the 50 and 200 day MA suggests further gains could be on the cards, though the fact that the 200 day MA is still pointing down suggests some degree of caution.

Trend line support at 0.8040 from the recent lows at 0.7755 also suggests some degree of support.
A break above the 0.8175 level does have the potential to target a move towards 0.8400 on an inverse head and shoulders break out

Even allowing for this potentially bullish scenario playing out a stronger euro is not in Europe's interests and it remains likely that the ECB will at some point have to alter monetary policy to avert further stresses in European markets sometime in 2013, thus weakening the euro, and sending it back towards the lows this year.