Sterling vulnerable after UK downgrade, gilts underpinned

Sterling looks wobbly following Britain's loss of its top-notch credit rating, but UK government bonds are likely to be more resilient, given the prospect of more buying by the Bank of England.

Strategists on the buy and sell side expect the already-weakening pound to test $1.50 soon. It fell by almost a cent to around $1.5160 after the Moody's downgrade late on Friday, just off Thursday's 2-1/2-year low.

Sterling's downtrend is well established, and the rating cut should have come as little surprise to investors. For the government bond market, the bigger event was last week's revelation that Bank of England Governor Mervyn King and two colleagues wanted to print more money to buy gilts.

They were outvoted this month, but the greater prospect of the central bank, which already holds about a third of the stock of UK government debt via its bond-buying programme, soon opting to buy another 25 billion pounds ($38 billion) of gilts should keep UK borrowing costs low.

"The UK's downgrade from triple-A is very much priced in and anticipated by professional investors," said Andrew Wells, Global Chief Investment Officer, Fixed Income, at Fidelity Worldwide Investment.

"I don't think savers need to worry about receiving a pound back on their UK gilts. The worry is what that pound will buy internationally."

Ten-year gilt yields have already edged up from historic lows around 1.5 percent last year to 2.1 percent as the easing euro zone debt crisis has robbed Britain of its safe-haven status.

If the Bank of England chooses to print more pounds, gilts will be shored up, but the law of supply and demand dictates that sterling should weaken further, though Sunday stories in the UK press about a precipitous slide look overcooked.

"The comfort expressed by the gilt market is largely built on the idea that the UK can print its own money," said Daragh Maher and David Bloom at HSBC in a note to clients.

"However, while this may let bond investors sleep easier, it will keep sterling investors awake at night. If the ultimate solution is to turn the printing presses on, sterling will be hit."

HSBC has a year-end forecast of $1.48 and 0.91 pence per euro for the pound, from around 0.86 now.

Credit rating downgrades have had little impact on other major countries such as the United States and France, but the former has the world's reserve currency and the latter is supported by the European Central Bank's pledge to do whatever it takes to bolster the euro zone.

"The experience of the U.S. suggests that any impact will be reasonably short-lived. However, because sterling does not share the U.S. dollar's reserve currency status, the impact of a downgrade may be larger for the UK," said Kevin Daly at Goldman Sachs.

"The exchange rate has already been on a weaker trend as a result of the BoE's adoption of an easier policy stance, and this move could be exacerbated by outflows from overseas portfolio investors following Moody's announcement."

STEERING STERLING LOWER

There have already been indications that policymakers are content to see sterling fall further.

The Bank of England's quarterly report earlier this month suggested it was prepared to tolerate above-target inflation for longer, and one of its interest rate-setters, Martin Weale, said the pound might need to fall further to rebalance the British economy towards manufacturing and exports.

However, it has already fallen a long way from peaks around $2 in 2008 with little benefit to Britain's exporters.

Further out, Gerard Lane, equity strategist at Shore Capital, said the decline in North Sea oil production and the continued trade deficit suggested sterling should slide significantly.

"Sterling needs to fall to parity vs Euro and $1.35 to arrive at a 'fair' value ... in order to rebalance the UK economy ... and give our exporters a chance to grow," he said.

A big fall in the value of the pound would pose risks. Currency crises are inherently destabilising, and British consumers are already struggling to cope with high inflation while their wages only inch up. Higher prices for imports would add to the pain.

Fawad Razaqzada, analyst at GFT Markets, expected limited impact on shares when markets reopen on Monday but agreed an already weakening sterling looked vulnerable.

"We saw an immediate depreciation of the pound on Friday evening, and I suspect the move will continue on Monday," he said.

"All eyes are on the psychological 1.5000 level for GBP/USD now. But while the downgrade is, among other things, a psychological blow for UK investors, I wonder how much of this news was already priced in."

(Reporting by Alistair Smout, Jamie McGeever, Swaha Pattanaik, Anirban Nag and Simon Jessop; Writing by Mike Peacock; Editing by Will Waterman)