Pound falls on Bank, offsetting coalition relief

 

Sterling fell and gilts rallied on Wednesday after the Bank of England's UK inflation report was seen as more dovish than expected, offsetting a relief rally in the pound after a UK coalition government took shape.

British inflation will fall below the Bank of England's 2 percent target even if interest rates stay at record lows and the new government does not put in place extra fiscal tightening, Bank forecasts showed on Wednesday.

In its quarterly Inflation Report, the Bank said downside risks to economic growth in the near term had increased and the pace of recovery remained uncertain, and indicated that interest rates may stay low for longer than markets expect.

Sterling fell around 90 pips versus the dollar before steadying to trade flat around $1.4940 by 11:30 a.m.. It had risen to a session high of $1.5046 earlier, aided by a strong rally in the euro after strong German and Italian growth figures.

The euro rose 50 pips to a session high of 85.21 pence after the inflation report before easing to trade up 0.3 percent at 84.90.

The June gilt future rallied more than 10 ticks to 116.95, having stood at 116.82 beforehand.

"The bottom line is that CPI will stay under the 2 percent inflation target ... interest rates won't rise as much as market expectations. Sterling sold off on this" said Adam Cole, global head of fx strategy at RBC.

Bank of England Governor Mervyn King said the financial crisis is far from over, and that problems in the banking sector now risk spilling over into a sovereign debt crisis. He also said the central bank has not ruled out further asset purchases to try to stimulate the economy.

UK COALITION

Sterling's fall came after a relief rally triggered late on Tuesday when Conservative Party leader David Cameron took over as prime minister and said he planned to form a coalition government with the smaller Liberal Democrat party.

Cameron's move into No. 10 Downing Street removed some of the uncertainty that drove sterling to a 13-month low against the dollar last week after an inconclusive election gave no party an absolute majority in parliament.

"The Conservative/Liberal Democrat coalition was the best solution for the markets, but of course there is still some uncertainty as to how the two parties will work together" said Lauren Rosborough, senior currency strategist at Westpac.

Analysts say PM Cameron has so far set out only a portion of the spending cuts and tax rises that will be needed to make a significant dent in the UK's deficit, forecast to reach 163 billion pounds or more than 11 percent of gross domestic product this fiscal year.

He is expected to face a difficult balancing act meeting financial market expectations for deep deficit cuts while avoiding alienating voters who have just entrusted him with power.

"The relief rally has petered out but I do expect the new government to take quick action on spending cuts which should keep the ratings agencies on side" said Kenneth Broux, market economist at Lloyds Banking Group.

The dire state of the UK's public finances has been a cause of concern for ratings agencies, with investors sensitive to the potential for a downgrade to the UK's sovereign rating.