British Pound Sterling: GBP, USD and possibly EUR, face up to the prospects of increasing deflationary risks

Last Updated on Tuesday, 24 January 2012 12:46 Written by Sam Coventry Tuesday, 24 January 2012 12:43

Foreign exchange analysts and exchange rate forecasters face the problem of understanding the impact deflationary risks will have on currency markets.

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British Pound Sterling (GBP) in US Dollar (USD): GBPUSD is 0.05% higher on the day at 1.5575.

British Pound Sterling (GBP) in Euro (EUR): GBPEUR is 0.16% higher at 1.1977.

British Pound Sterling (GBP) in Australian Dollar (AUD): GBPAUD is 0.6% higher at 1.4878.

A key theme exchange rate analysts are having to increasingly face is that of deflationary pressure.

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Pound exchange rates are already contending with the issue; since it was announced that UK inflation fell to 4.2% in December the British pound has felt the pressure of expectations that the Bank of England will expand their quantitative easing programme.

Most investment banks are calling an expansion of the programme in February, when the current round expires.

The same dynamics are likely to apply to the US dollar and the euro as we head into the latter part of 2012 say exchange rate analysts at Bank of America in a note to clients released today.

Bank of America say:

"Of course, while inflation has more straightforward impact for rates, the FX implications around broader deflationary risks are hazier. Deflation concerns may have diminished for the moment as markets now worry around the potential for another spike in oil prices from tensions in the Strait of Hormuz.

"But growth conditions and excess capacity still point toward lower prices and additional policy action. Not only is further QE likely out of the Fed, but there is a general expectation that the Bank of England will announce an increase in their asset purchase price target next month."

However analysts say that they still look for a relatively modest decline in the USD in their forecast horizon, led by their very long-term target for the euro to 1.35 by the end of next year.

The currency note says:

"The impact of the third go-around for QE for Fed should still be negative, but may run into diminishing returns for FX markets.

"The wrinkle in the outlook will be if deflationary pressures grow in the eurozone to the extent that the ECB feels pressed into expanding their own balance sheet.

"Admittedly, the bar for such a move would likely be very high, given their own set of constraints and reluctance to act. But the combination of growing deflation risks and central bank policy would likely result in a more diminished FX response to such policy."