So, a comparatively quiet non-farm payroll Friday draws a hectic week to a close, lending us the opportunity to take stock of a major shift in market sentiment and to look ahead to next week’s activity. Thursday’s disappointing UK services sector figures were overshadowed by events in Europe. In response to eurozone inflationary pressures, ECB President Trichet’s groundbreaking remarks on the likelihood of a rate hike within the next month placed the euro firmly on the front foot against all its counterparts.
With the ECB now well ahead of the BoE in terms of rate hike expectations, sterling looks set to weaken to levels potentially as low as 1.1360 against the euro in the coming weeks and months, though it should remain stable against a broadly weaker US dollar. With the single currency reaching a one-month high against sterling today, investors have clearly (and understandably) responded very positively to Trichet’s hawkish tones. However, perhaps greater caution would be sensible as a rate hike could yet prove highly damaging for the eurozone’s periphery members, where bond yields and unemployment remain harmfully high and growth remains elusive. The prospect for higher rates offers investors a greater return and has lifted euro demand, but, if they cause deepening debt crises in the PIIGS, the prospects for the European economic recovery, and therefore the euro, will suffer considerably.
Taking a longer term view, the market at this stage is only pricing in a single rate hike from the ECB this year (April) in order to bring eurozone inflation back to target (2.0%), however, markets are pricing in up to three UK rate rises this year, which could give sterling the edge in later months.
After this week’s excitement, we are likely to see something of a lull next week with few major data releases or announcements due. Following the heightened volatility that has epitomised the past few sessions, it will be interesting to see whether a broader trend of euro strength is consolidated. The market’s sole focus will on Thursday’s Bank of England rate statement, where investors will watch for any clues of an unlikely replication of the ECB’s hawkish response to inflation. Whilst UK inflation is at a far more alarming level than that of the eurozone (4.0% vs 2.4%), the majority of the MPC voters seem determined to maintain their ‘wait-and-see’ approach with regard to the effects of austerity measures on the UK’s stubbornly fragile recovery. No change to the 0.5% UK interest rate is therefore widely expected. That said, no one was seriously entertaining the idea that a rate rise from the ECB would be brought forward by five months this week!
In the US, today’s Non-Farm employment results for February met positive expectations and further evidenced the promising signs of economic recovery that we’re seeing on the other side of the Atlantic. Nonetheless, a radical improvement, which remains highly unlikely, will be necessary before the Federal Reserve decides to change course from its strong commitment to keep rates at record lows. It is this factor which limits sterling’s downside risks against the dollar and provides hope of a long-term continuation of this year’s gradual GBP/USD strengthening.
Richard Driver
Analyst – Caxton FX
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