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Today the BOE increased QE by GBP50bn and kept the benchmark interest rate at 0.5%, as expected. In his letter to the Chancellor BOE Governor Mervyn King said that the extra QE was necessary to ensure inflation doesn't undershoot its target.

Even though King said that the growth picture had picked up at the start of 2012 painting a more positive picture of the UK economy, headwinds remain. But his and the committee's biggest concern remains inflation. The MPC saw the January inflation figure (released next week to the public) before it made its policy decision. CPI is expected to fall to 3.6% from 4.2% in January because of last year's VAT rises falling out of the index. However, King went on to say that prices are likely to decline further due to rising unemployment and a reduction in import price inflation.

The Governor of the MPC gave no indication of future policy direction and instead said that the Committee judged more QE necessary due to the weak near-term growth outlook and the threat of inflation undershooting its target in the medium term.

Thus, going forward the prospect of more QE will depend on the tussle between stronger growth on the one hand but downside inflation risks on the other. But on balance I would argue that the Committee is taking a cautious approach to QE and the future trajectory of BOE asset purchases remains far from certain.

This is backed up by the minutes from the Bank's last meeting in January when the some Committee members thought that the speed and extent of the fall in inflation in the coming months was less certain. Interestingly, some believed that the future risks to inflation were finely balanced, and for them it was less clear that inflation would fall below target in the medium term.

Without further QE in the bag the pound has rallied. GBPUSD was getting stuck at 1.5850 prior to the BOE announcement, but has since rallied to 1.5880. In the very near-term if GBPUSD can break above 1.5900 then tough resistance lies at 1.5940, but the road to 1.60 actually depends less on QE and more on the overall risk environment. In the last 6 months the pound has had a very strong positive correlation to risky assets like the SPX 500 at 63%, which means that the pound moves with the SPX 500 63% of the time, this compares with the 10-year UK Gilt yield, which only moves with the pound 45% of the time.

Correlation matrix for GBP: SPX 500, Brent, 10-year Gilt yields, DXY and EURUSD

 

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Source: Bloomberg

 

So if you want to know where the pound is going watch what risk is doing. The Bank of England only has a short-term impact on the pound, so the future trajectory of the pound will depend on macro events such as the outcome of the Greek austerity talks and the ECB press conference that takes place later.

Interestingly, the pound has diverged from risk in the last few hours. EURUSD has fallen 50 pips while European stocks have given up some of their earlier gains as some negative headlines have trickled out of Europe. Due to the pound's relationship with risk that we mention above, this could cap GBPUSD gains in the near-term and 1.5880 may be the high for now.

GBPUSD and the FTSE 100:

 

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Source: Bloomberg

 

More interesting is EURGBP, after running into resistance at 0.8380 earlier it has fallen sharply post the BOE meeting. The next support zone of note is 0.8325. Below here we could see to 0.8300 then 0.8250.

EURGBP has tumbled sharply today but may run out of steam around 0.8225 - a cluster of hourly smas as you can see below.

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I expect the pound and euro crosses to be volatile during the ECB meeting and the press conference scheduled for Greece later this afternoon. I am staying out of the markets as it could be a choppy few hours ahead, I'd rather wait until the event risks are out the way and the dust has settled.

Best Regards,

Kathleen Brooks| Research Director UK EMEA | FOREX.com

d: +44.(0).20.7429.7924 | f: +44.(0).20.7929.2010 | M: +44 (0) 7919.411.957 | e: kbrooks@forex.com| w: www.forex.com/uk

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