With no end or solution in sight for the eurozone, the Bank of England (BoE) is trying to protect the UK economy from being dragged down by the woes of the eurozone. As inflation starts to ease in the UK economy, the question now is whether the BoE will again expand its asset purchasing programme, otherwise known as quantitative easing.

UK still suffers from stagnated growth but keeps AAA rating

Economic data showed that the UK economy bounced back in the third quarter of 2011 by 0.6%, but the rise was not enough to ease fears about a double dip recession. The latest data suggest that the economy in the fourth quarter probably remained stagnant. The UK housing price index showed that figures hit the lowest level in four months in December while unemployment rate rose to the highest level since 1996. However, in contrast to the eurozone countries, the UK’s credit rating remained untouched by recent downgrades by the rating agencies and managed to keep its triple-A rating.

Sterling moves from safe haven to funding currency

Things appear to be changing for sterling. About a month ago sterling was considered Europe’s new safe haven as the UK government bond yields reached an all time low. We have observed a safe haven demand for sterling as investors have been looking for an alternative to the euro. In the past few weeks, investors were selling the euro to buy high-yielding currencies but as the confidence in the safe haven status of the UK declines, sterling’s buying momentum has slowed and investors are looking to sell the pound instead. Further quantitative easing is expected from the BoE and interest rates are forecasted to remain at ultra low levels, which may further weigh on the sterling. Economists suggest that investors may switch to sterling as a funding currency in order to buy higher yielding ones such as the Aussie and the Canadian dollar.

Inflation in the UK cools

The Office for National Statistics showed that the British annual inflation fell sharply in December to 4.2% from a previous 4.8% in November. The drop was the biggest fall in the annual CPI rate since April 2009, when the UK economy was struggling to escape a deep recession. As the UK economy struggles with a sluggish growth, the fall in inflation creates a more comfortable environment for the Bank of England to print more money.

More quantitative easing on the way?

Following the softer inflation figures in December, speculators argue that the Bank of England may print more money for asset purchases to support the economy in its next policy meeting. The £275 billion purchasing programme is expected to end in February and, given the fragile economic conditions and the fall in inflation, the Monetary Policy Committee (MPC) may further extent its easing program while interest rates are kept at the ultra low levels of 0.5%. In the scenario where poor data continues to hit sentiment in the market and the MPC expands its bond buying program, sterling may be further under pressure to seek new lows.

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