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Interview given to Pro Finance by Steven Pearson, chief currency strategist from Bank of Scotland Treasury. 08.02.2008. BOS Treasury is Bank of Scotland Plc's department which in its turn is a member of HBOS Group.

Yesterday the Bank of England, as expected, cut the rate 0.25% to 5.25% and it was said in the accompanying statement that this decision will help to reach the target inflation of 2% in the medium term. What actions shall we expect from the Bank in the future? Do you think that it will have to adopt more aggressive stance of monetary policy easing due to risks to economic growth?

I don't think that there will be a more aggressive rate cut than it is currently expected by the market, which is 100 basis points. The Central Bank made a strong emphasis on current inflation and outlooks for inflation in its yesterday's statement, so I think that the Bank of England will proceed with caution. I don't think that we will see the same monetary policy style in the UK as in the USA, and the Central Bank will be much more gradual in its approach though this can lead to the significant short-term interest rates cut.

Do you think that the market is right in its UK interest rate expectations?

I think the final assessment is mostly correct. The market participants expect that the BoE rate level will reach 4.00% - 4.25% in one year's time, and I think they are right. However, they believe that we can get there within the next 6 months, but I suspect that it will take much longer. I think that this year the rate will go down to 4.25%, this is another 100 basis points cut, but the speed with which we get there will be key to the exchange rates. If Central Bank is gradually cutting the rates down to 4.25% over the next 8 months, this can hardly affect British currency. Moreover the current situation in the USA and Eurozone is the key for GBP/USD and EUR/GBP. The things look quite interesting in Eurozone: ECB is gradually changing its position to a more dovish one. I think Trichet made it clear yesterday that the rate cut is just a matter of time. If economic conditions will continue to worsen the same way they have been worsening recently, it should not be long before the ECB cuts the rates, which will put euro under pressure against dollar, pound and other currencies.

Indeed Trichet pointed out increased threat to economic growth in his speech, this made the market participants to review their expectations of ECB rates. Meanwhile UK economy growth rates are under threat as well. Do you think that the BoE rate cut expected by the market and by you will be enough to minimize economic risks?

No, now it's already too late to stop the slowdown in economic rates. The central banks can only cushion the blow and bring the economy to the point where the growth will start again. So the Bank of England will gradually reduce the rates but along with weakening of inflation pressures. Though I think the European Central Bank will ease monetary policy faster pace than it is currently expected by the market, and that makes me a bearish in euro/sterling. We expect the pair to come back down to 0.73/74 within the next 6 months and further down to 0.72/70 by the end of the year.

One more question concerning UK economy. Recently we've had a session with Ian Shepherdson at HFE and we came to the conclusion that despite aggressive rate cuts by FED, situation in the housing market will continue to stay gloomy and the bottom of the correction is still very far away. Now we can also see signs of slowing in UK housing market. Do you think that situation in the US is possible in UK? How far do you think this weakening will bring us in terms of consumer spending?

You know I can't answer this question because I work for the largest mortgage lender. I 'd prefer no to comment the situation on the housing market but I think you can use your imagination. :-)

Ok, let's forget about this question. It seems to me I understood your answer. Let's talk about the US currency instead. The American dollar long-term downtrend in the first part current cycle was based on the US economy structural problems. In 2006 and 2007 the currency depreciation was also supported by decrease of rate differentials in comparison with other countries, in particular Eurozone. However today the main theme for market participants is risk reduction in situation of growing fears about economic growth prospects in different countries. Do you feel this rates differential issue is still vital, and if not, when is it going to take its place among the key currency market drivers?

Interest rate differentials has always been an important currency market driver, especially changes in the expected interest rates differentials. But we shouldn't forget that this is not the only factor influencing the market performance. You mentioned some important aspects which are in the key now, for example, so-called risk aversion. At the moment consequences and scale of risk aversion among global investors have a more powerful influence on the currency market' rate differentials issue. It's extremely difficult to track changes through time. But I believe over the course of this year risk aversion will become more important, while rates differentials for dollar won't get any worse. By some measures I can even suggest that soon the market will stop to except further dollar weakening. We have already seen the worst of rate differentials. And there is a number of positive factors for the US currency. In particular, the decrease in orders caused by slower economic growth rates and risk aversion may support it. If I'm right and we are in the midst of a material and prolonged economic slowdown, we can expect an improvement of the US trading position due to import reduction. The commodity prices will go down, which will lend further support to the US currency and also improve its trading position. Emerging markets' appetite for the US capital put pressure on the dollar. Equity capital outflow to the emerging markets is one of the most important tendencies during the last years. But it's very doubtful that this tendency will survive the global economic slowdown. In the nearest future the situation is going to change and this can be considered as positive factor for dollar improvement.

Are you expecting any changes in terms of this long-term down trend in dollar?

I think we can expect a material and permanent shift in the dollar adjustment this year. The currencies of the emerging world with large current account surpluses and huge foreign exchange reserves will become more stable. I think we start to see a more record price appreciation in the yuan, other Asian and GCC currencies. Euro at 1.5, 1.6 and even 1.7 won't make a lot of difference to the US global trading position. In fact it could probably make it worse. If the US really want to improve the trading position, they have to become more competitive in the emerging markets and make emerging world currencies stronger. And this is a very difficult thing to achieve. But still inevitable. So the dollar is likely to raise against the developed countries currencies and decline against emerging countries currencies. In the nearest future the commodity prices will go down, which can improve the trade deficit situation in the US and stabilize the dollar.

Could you share you view on this year dynamics of EUR/USD and GBP/USD?

I think the both pairs will go down. At the beginning of this year euro was trading in the range 1.43/1.49 but eventually a number of factors will cause euro decline. In particular, I can point out three dollar-positive aspects: firstly, the ECB will eventually cut the rates, secondly the commodity prices will fall, and finally the US trade balance will start improving. Those three factors can help the dollar to recover. At the same time sterling is very closely correlated with euro and has already fallen. Our 6-months forecast for GBP/USD is 1.92 (ProFinanceService.com: the figure is from the bank's official research which was issued before the recent pound decline).

G7 meeting starts tomorrow. How, do you think, it will affect the financial markets?

I think it will have very little effect on financial markets and won't bring anything new. Policy makers' attention is focused on other more vital and urgent issues. For example, the credit crisis and its effects. As for yuan, it will be accused of too slow appreciation, though I'm not sure that it has appreciated at all. It is doubtful that G7 leaders will be more aggressive towards China currency. I don't think the communique will be different from the one issued after the previous meeting.

Mr. Pearson was interviewed by Dmitry Khrabrov ProFinanceService.com