The UK - stuck between a rock and a hard place

The pound has been taken a bettering this morning after credit rating agency Moody’s said that the UK’s Aaa credit rating was at risk if 1, growth continues to slow and 2, the UK decides to slow down its fiscal consolidation plans. However, for now Moody’s said the UK’s rating is stable.

In recent weeks there have been calls for the Government to slow down the pace of deficit reduction to foster stronger growth, so it looks like Chancellor Osborne is damned if he does, damned if he doesn’t…

But what has this done to the markets?

Interestingly, the renewed focus on the UK’s sovereign rating had an immediate impact on Gilt yields and FX. 10-YEAR Gilt yields moved higher as credit risk was perceived to have increased, while the pound fell. In the past rising yields have been a reflection of interest rate expectations, which have boosted currencies. Now though, with the BOE most likely on hold, today’s rise in yields is due to an increase in credit risk, which is pound negative.

The chart below shows the yield spread between UK and US 10- year yields (white line) and GBPUSD. Although the spread has widened, this is not supporting the pound, which has fallen below 1.6400.



Credit risk is not positive for FX, and for as long as the spectre of a downgrade remains over the UK the pound may find it hard to rally. Of course, the US also has its debt problems, but the credit rating agencies are not concentrating on them right now.

For the longer-term, if we see a continued deterioration in the UK’s growth outlook then this is pound negative for two reasons: 1, it makes rate hikes from the BOE more likely and 2, it could impact the UK’s credit rating…. So, between a rock and a hard place….

EURGBP: The same pastern can be seen here. German Bunds continue to attract safe haven demand, yet investors have been spooked by the Moody’s comments regarding the UK and Gilt yields have moved higher. So the spread between German 10-year yields and UK yields (white line on chart) has turned lower, while EURGBP has surged above 0.8950, as you can see in the chart below.


It is too early to say, but the one thing that the FX market does not like is credit risk. In the past rising yields meant a strengthening currency. This is not necessarily the case if we are moving into a period where yields are rising because of a greater perception of credit risk.

The UK and the US are in the immediate firing line of the credit rating agencies, in our opinion. Germany’s credit rating is not at risk at this juncture, since its fiscal position is in much better shape than the UK and US. Thus, in the medium to longer-term, if the market focuses on fiscal issues and credit-worthiness this is euro positive and dollar and pound negative.

Source: Forex.com

08.06.2011