UK s Downgrade amp EURGBP

As the UK loses its AAA credit rating for the first time since the late 1970s and most of the Eurozone nations have had their credit rating or outlook downgraded since two years ago, the ascent in EUR/GBP remains intact.

From a policy (and politics) standpoint, the UK faces the clear trajectory of embarking into fresh quantitative easing with an unspoken currency policy of a weak sterling. While credit rating agencies focus on the “debt” portion of the Debt/GDP ratio, they cannot ignore the GDP part as the UK enters its third recession in five years. Unlike in Greece or Ireland, where severe austerity has produced results in stabilising the fiscal deficit, the UK missed its own fiscal objectives and is inevitably entrenched into deeper fiscal tightening and monetary easing.

The Eurozone is not in an envious position either. With four quarterly GDP contractions out of the last five, Eurozone nations are grappling with their own such as policy continuity in Italy, Greece and Spain. Italian voters may need a Greek-like scare to start a second round of votes and avoid the return of Berlusconi to power at the expense of blocking the Mont-led reforms.

But unlike the Bank of England, the ECB is undergoing an implicit tightening policy by staying away from buying bonds. Its balance sheet shrank 8.8% year-to-date versus a decline of 1.4% for the Bank of England. The currency implications of these contrasting policies are likely to further empower EUR/GBP once the BoE embarks in a fresh round of asset purchases.

FX Speculative Positioning Backing EUR/GBP

We said last week GBP was from oversold as Sterling longs vs USD were NET -16,776 contracts among speculative futures traders– meaning the number of contracts short GBP vs USD exceeds the longs by 16,776 contracts. The amount is well below the record 76,745 of net shorts reached during the British elections of May 2010 – when traders feared a Labour Party victory would embark the UK into “tax & spend” policy.

The latest CFTC data showed GBP shorts to have deteriorated (rose) to 23,365 contracts from 16,776 contracts, dragging down GBP/USD to 1.5080 from 1.5400.

Looking at the speculative positioning for each of the EUR and GBP against the USD, we conclude that the impact on EUR/GBP is for more downside. While net longs in GBP/USD are in negative territory (net shorts), they remain four times less than their record highs (shorts) of 76,745 contracts. This contrasts with net longs in EUR/USD, which currently amount to a net 19,103 contracts, well below the 99,516 contracts high in May 2011 and 10 times less than the record high of 120,000 in May 2007.

Thus, from a speculative positioning perspective, greater downside room remains for GBP/USD, in contrast to EUR/USD’s modest long positioning. By default, this may lead to further bullishness in EUR/GBP, driving the pair towards 0.88, before the intermediate target of 0.91 is finally recaptured. Preliminary support stands at 0.8500.