Sterling will continue to be vulnerable to the debt concerns, especially with political uncertainties adding to fears that the government deficit situation will not be addressed. Indeed, it is certainly possible that confidence will deteriorate further in the short term. Volatility levels are liable to remain sharply higher in the short term, especially after the Bank of England inflation report. The report could lift Sterling briefly, but rallies to above 1.5750 against the dollar will soon attract selling pressure. From a medium-term perspective, losses to the 1.52 region remain realistic.

Sterling came under renewed selling pressure during Tuesday with a further test of support near 1.5550 against the US dollar. The UK trade deficit was wider than expected with an 11-month high shortfall of GBP7.3bn for December which will tend to increase fears over the economic outlook. There was also a warning from ratings agency Fitch that the UK was the most vulnerable of the AAA-rated economies to a credit-rating downgrade. Sterling recovered to around 1.57 against the dollar later in the US session, primarily due to the impact of general dollar weakness.

The Bank of England inflation report will be extremely important for Sterling later in the day and is liable to trigger further Sterling volatility. The currency could gain some support on higher than expected inflation forecasts or a more upbeat survey of the economy from Bank Governor King, although he may be more cautious over the economic outlook which would tend to erode currency support.