Sterling fell 4.25% from the high on December 28 to yesterday. It has been confined to yesterday’s range today. After finishing below the lower Bollinger Band yesterday, it has moved back into the band today. 

The Bank of England meets tomorrow. It is way to early to seriously look for a change in policy. At most, MPC member McCafferty may abandon his formal call (dissent) for an immediate rate hike. He has done this before. We suspect if the hawk does rejoin the majority, it has no more significance than his dissents. 

Why has sterling performed so miserably?  There are two main drivers. First, the economic data has disappointed and investors have been pushing out their expectations of the first hike. It has shifted from late-Q2 to late-Q4. Second, there is concern about a referendum on EU membership that could be held in May.  

The UK has a full economic calendar next week. Inflation, employment and retail sales are the main features. The risk is for continued soft data. However, the market appears to have largely adjusted to the slower growth profile that the recent string of data indicated. On New Year’s Eve, the December 16 short-sterling futures contract implied a 3-month yield in 12-months’ time of 104 bp. Yesterday it made contract highs to imply a 74 bp yield. 

The March contract implied a yield of 64 bp at the end of last year and 60 bp at close yesterday. The spread between the two contracts fell to 16 bp yesterday. Barring the pricing in of a rate cut, we suspect there is not much more scope for spread compression. Combined with our technical analysis, we suspect that the decline in short-term UK rates is nearly at an end.   

The US two-year premium over the UK peaked at 46 bp on December 29. This is the largest US premium since 2000, when it peaked just below 50 bp. Thus far this year, the spread has moved sideways. It is at 42 bp now

If the first leg of the sterling bear case may have nearly run its course, what about the other leg, the referendum?  The news stream is likely to improve in the coming weeks. Note that the predictive markets (where people can wager on event outcomes) expect UK voters to approve remaining in the EU 3:1.