Pound Logs Record Weekly Drop Against Euro as Economy Slumps

By Andrew MacAskill

Nov. 15 (Bloomberg) -- The pound had its biggest weekly against the euro since the common currency's 1999 debut as evidence mounted Europe's second-biggest economy is gripped by a recession.

The pound was near an all-time low against the euro and traded below $1.50 yesterday for a third day. The Bank of England indicated on Nov. 12 it will keep cutting interest rates as the economy slumps.

``It is going to be a while before we see a turnaround in the fortunes of the pound,'' said Kamal Sharma, a currency strategist in London at JPMorgan Chase & Co. ``The economic data out of the U.K. continues to deteriorate and against that backdrop we are going to see sterling weakness.''

The pound rose to 85.76 pence per euro late yesterday in London, from 86.06 pence on Nov. 13, when it dropped to a record 86.63 pence. The weekly loss was 5.3 percent.

Against the dollar, the pound was little changed at $1.4844, down 5.1 percent from Nov. 7.

Europe's economy fell into its first recession in 15 years in the third quarter, the European Union said yesterday. Gross domestic product in the 15 euro nations shrank 0.2 percent from the previous three months, when it also contracted 0.2 percent.

Investors should sell the pound until it reaches $1.40 as the weakness of the economy means the Bank of England may have to keep cutting interest rates, according to Jeremy Stretch, senior strategist in London at Rabobank International, the third-largest Dutch banker.

`Play Short'

``With the pound you have to continue playing it short, particularly against the dollar,'' Stretch said. ``The pound is going to take a thumping. At the moment it is perceived to be one of the currencies with the greatest underlying problems.'' A short position is a bet the value of an asset will decline.

The British currency's trade-weighted index dropped 5.2 percent this week to 77.62, near the lowest level in at least eight years, according to indexes compiled by Deutsche Bank AG, the world's biggest currency trader. It fell to a record 76.95 yesterday, the weakest since at least January 2000.

The U.K. economy will contract by an annual 1.8 percent in the first three months of the year, according to forecasts from the central bank released on Nov. 12. ``We are certainly prepared to cut the bank rate if that proves to be necessary,'' Bank of England Governor Mervyn King said that day.

``King basically endorsed the pound's decline as a way to revive the economy,'' said Lee Hardman, a currency strategist in London at Bank of Tokyo-Mitsubishi Ltd. ``Investors have seen this like a red flag to a bull and are selling it.''

Currency Forecasts

The pound may decline to $1.40 and 88 pence against the euro by year-end, Hardman said. That compares with $1.60 and 80 pence a euro, the median analyst estimates in a Bloomberg News survey.

U.K. policy maker Andrew Sentance said Nov. 13 the pound's slide against the dollar and the euro will make it easier for manufacturers to cope with a recession. BT Group Plc, the U.K.'s largest phone company, said the same day it aims to cut about 6 percent of its workforce in the year through March.

The pound's 14-day relative-strength index versus the euro, a technical indicator some traders use to forecast changes in price direction, was at 24.5 yesterday, below the 30 threshold that signals a rebound for a third day.

The U.K. currency rose for eight days when it last fell below 30 on Sept. 3. The pound advanced to as much as 85.25 pence a euro earlier yesterday.

Bond Yields

The yield on the U.K. two-year note, more sensitive to interest rates, fell 33 basis points in the week to 2.15 percent. The 4.75 percent security due June 2010 rose 0.47, or 4.7 pounds per 1,000-pound ($1,484) face amount, to 103.94.

The yield on the U.K. 10-year gilt declined 13 basis points to 4.06 percent. Yields move inversely to bond prices.

The yield on the German two-year note rose above that of the comparable gilt for the first time since December 1993. The yield on the benchmark German note was at 2.21 percent yesterday.

Investors should favor two-year gilts over the German equivalent as the worsening economic outlook in the U.K. prompts the Bank of England to lower interest rates more rapidly than the European Central Bank, according to Nick Stamenkovic, a fixed-income strategist in Edinburgh at RIA Capital Markets.

``It certainly doesn't look like the ECB is going to cut rates as aggressively as in the U.K.,'' he said. ``The Bank of England is pulling out all the stops to prevent a prolonged slump and that makes the two-year note attractive.'' The U.K. two-year gilt may fall to 2 percent by year-end, he said.

The yield, or spread, between two- and 10-year U.K. government bonds increased to the most in 15 years as investors bought shorter-dated notes, betting the central bank will reduce borrowing costs to bolster the economy.

The spread was 190 basis points, near the widest since March 1993, from 170 basis points a week ago. The so-called steeper yield curve suggests investors have become more pessimistic about the outlook for economic growth.

To contact the reporter on this story: Andrew MacAskill in London at amacaskill@bloomberg.net