Sterling resilient despite downgrade

Sterling fell sharply on Thursday after Standard & Poor's rating agency said it had revised its outlook for the UK economy from stable to negative. This has historically led to a downgrade in credit ratings on approximately 30% of occasions for all economies, and could lead to higher costs on the UK's ballooning public borrowings if the Triple-A rating is eventually lowered.

Whilst the world.s second largest economy, Japan, has only an AA rating, a much greater proportion of the UK's borrowings are funded by overseas investors. Sterling is therefore arguably at higher risk should international investors become increasingly nervous about the UK's ability to repay borrowings.

That said, the Pound quickly recovered and its resilience to such a setback appears to support the argument that Sterling has been oversold. A better than expected retail sales performance in April and some relief that the UK's first-quarter growth performance was left unrevised, boosted optimism of a recovery.

UK data this week include the CBI distributive trades survey and Nationwide house prices on Thursday. These, along with consumer confidence on Friday, are not expected to suggest that the UK economy is in robust shape, but could work in Sterling's favour if the data exceed expectations.

US Dollar (USD)

The US Dollar was comfortably the worst performing of the major currencies last week. Although Sterling fell by three cents after Standard & Poor.s downgrade of the UK's outlook, it later went on to reach a five-month high of 1.5945. The mere thought that a similar fate could ultimately befall the US was sufficient to provoke a rapid US Dollar sell-off. Perhaps this is less surprising given that US government debt is considered by economists as a benchmark for 'risk-free' interest rates and how strongly this perceived safe-haven status has underpinned the US Dollar in recent months.

The GBP/USD rate closed up 4.97% at 1.5929, from 1.5175 a week earlier, benefiting those converting Sterling into US Dollars.

This week.s calendar includes existing home sales on Wednesday and durable goods orders on Thursday. Potentially the most market-sensitive, Friday's second estimate of first-quarter economic growth (Gross Domestic Product) might ease concerns over the US economy if the first estimate of a 6.1% annualised contraction is shown to have been overly pessimistic.

Euro (EUR)

The Pound initially rallied strongly against the Euro, reaching an intra-week high of 1.1455 on Thursday morning. Falling to 1.1270 in the aftermath of the UK.s downgraded outlook, Sterling quickly recovered but was unable to re-test these highs. Despite several Euro zone economies having suffered a similar fate already, the Euro was a major beneficiary as investors attempted to evaluate which of the major developed economies remain the more creditworthy. The Euro zone's manufacturing and services sectors also shrank by less than expected in May, and this also contributed to the Euro.s more favourable outlook.

The GBP/EUR rate closed up 1.21% at 1.1379, from 1.1243 a week earlier, benefiting those converting Sterling into Euros.

Friday's consumer price inflation and unemployment data are the key remaining releases this week. Weaker than expected data could increase expectations that additional interest rate cuts, or other less conventional measures, may be required and undermine some confidence in the Euro.

Canadian Dollar (CAD)

As with other Sterling exchange rates, the GBP/CAD rate was subjected to volatile trading conditions last week, reaching an intra-week high of 1.8089 on Thursday. Canadian consumer inflation fell to a fourteen year low of 0.4% in April, although this had a relatively muted impact on the Canadian Dollar since the Bank of Canada has already committed to keeping interest rates low for an extended period. A surge in oil prices to above $60 per barrel for the first time in six months underpinned support for the Canadian Dollar, which ended the week strongly after a third-consecutive monthly rise in retail sales in April.

The GBP/CAD rate closed down 0.21% at 1.7825, from 1.7863 a week earlier, benefiting those converting Canadian Dollars into Sterling.

Commodity price trends and export performance are key influences for Canada.s economic performance. Friday's current account data, which records the values of exports relative to imports, could undermine the Canadian Dollar if a bigger than expected decline in exports contribute to a widening deficit.

Australian Dollar (AUD)

The Australian Dollar was initially supported last week by rising global stockmarkets and higher commodity prices. However, as global stockmarkets retreated sharply on Thursday, the Australian Dollar was unable to hold on to these gains against Sterling. The minutes from the Reserve Bank of Australia's May meeting, at which interest rates were left unchanged at 3%, gave rise to some speculation that it might again leave interest rates at 3% in June if financial market conditions improve.

The GBP/AUD rate closed at 2.0346, up 0.45% from 2.0254 a week earlier, benefiting those converting Pounds into Australian Dollars.

Ahead of important economic growth data and the interest rate decision next week, investors will be focusing on construction activity (Wednesday), home sales and business investment (both Thursday) for confirmation that the Australian economy is one of the better positioned economies for recovery.

New Zealand Dollar (NZD)

The New Zealand Dollar advanced against Sterling over the early part of last week, buoyed by returning investor appetite for risk and stronger commodity prices. In an absence of major domestic data releases, the New Zealand Dollar.s performance was dominated by global influences. High volatility also characterized the Sterling/New Zealand Dollar rate; in just a seven-hour period on Wednesday Sterling climbed by more than five cents, although these gains were largely erased over the remainder of the week.

The GBP/NZD rate closed at 2.5658, down 1.05% from 2.5931 a week earlier, benefiting those converting New Zealand Dollars into Sterling.

Thursday's Annual Budget is the highlight of the domestic calendar this week. Following a week in which foreign exchange markets became very sensitive to the perceived creditworthiness of individual countries, the New Zealand Dollar could be at risk if the government fails to convince markets of a credible path to financial health over the longer-term.

South African Rand (ZAR)

The Pound traded in a range between ZAR 12.97 and ZAR 13.29 last week, but the Rand generally failed to find clear direction ahead of today's (26th May) first-quarter 2009 Gross Domestic Product (GDP) report. The GBP/ZAR rate closed at 13.179, down 0.08% from 13.189 a week earlier, slightly benefiting those converting Rand into Sterling.

However, Sterling again pushed closer towards last week.s highs after the economic growth report today confirmed that South Africa officially entered its first recession in 17 years; GDP fell an annualised 6.4%, much worse than expected after declining 1.8% (annualised) in the previous three months, raising speculation of an aggressive 1% interest rate cut later this week.

The Reserve Bank of South Africa will release its interest rate decision on Thursday and a fourth-consecutive 1% cut could potentially further undermine support for the Rand. Interest rate expectations may also be influenced by Wednesday's inflation data, strengthening the case for a smaller reduction if inflation remains more stubborn than expected.