August saw a collapse in global investor confidence which triggered huge losses in the stock market. Rating agency Stand & Poor’s downgrade of US debt proved the catalyst, but a variety of issues contributed to the slide in sentiment; global growth is stalling, the US economy is nearing another recession, and a long-term solution to the eurozone debt problem continues to evade us.
The US dollar and other safe-haven assets strengthened considerably amid the huge uncertainty that prevailed in early August but prospects for the dollar look negative. The Fed has announced that the US interest rate will remain at record lows until mid-2013, and debate within the central bank surrounding ‘QE3’ (further US quantitative easing) is ongoing. US economic data has broadly been very disappointing in recent weeks; hopes of a H2 pick-up in growth are diminishing and bets on another US recession are increasing.
Sterling enjoyed a strong few weeks, offering investors some safe-haven appeal of its own. With US and eurozone issues dominating the headlines, and with the Swiss National Bank and Bank of Japan taking measures to devalue their currencies, the market looked to sterling as a safer alternative. With confidence returning and risk appetite recovering, this theme has been reversed in the past week and the pound’s prospects are bearish; a poor growth outlook and a dovish central bank are weighing heavily.
Sterling/Euro
Eurozone concerns are at a reasonably low ebb at present; despite bond yields still at elevated levels, the ECB’s programme of buying Spanish, Italian, Portuguese and Irish bonds is a show of commitment that has gone some way to calming fears. Nonetheless, frustrations remain; the European Financial Stability Fund has not been expanded and is thus insufficient in size to deal with a Spanish or Italian bailout.
The proposal of a common eurobond has been rejected by Merkel and Sarkozy. Vague commitments to common governance and a Tobin tax were the main results of the two leaders’ last meeting, neither of which inspired much confidence. However, judging by the strength of the euro, the market seems willing to wait for officials to work out a longer-term answer to the eurozone’s structural debt problem.
The outlook for the ECB interest rate outlook is coming under increased scrutiny, in light of a slowdown in quarterly growth figures from Germany (0.1%), France (0.0%) and eurozone as a whole (0.2%).This slowdown is in line with a global trend however, as shown by a second quarter UK growth figure of 0.2%. It should be noted that Trichet was slightly more dovish at last month’s ECB press conference but nevertheless, the ECB have shown they are dedicated to controlling eurozone inflation and rate cut seems unlikely at this stage. The eurozone’s higher interest rate (1.50%) will continue to attract investment moving forward.
Last month’s MPC minutes made the UK interest rate outlook even more dovish, with the two remaining MPC hawks (Weale and Dale) abandoning their quest for a BoE interest rate hike. In addition, the recent Quarterly Inflation Report indicated a calmer outlook for inflation next year. With UK growth so weak, there is little pushing the BoE towards monetary tightening now.
Indeed, there is substantially more chance of further UK quantitative easing than of a rate hike. Last month’s manufacturing and construction PMI data was poor, as were retail sales and unemployment figures. The only saving grace was some strong growth in the UK services sector, which was enough to stave off fears of further UK quantitative easing for the time being. A poor showing in August’s PMI figures in coming sessions could well see this pair drop considerably, all eyes will be on the all-important services figure.
Sterling looks distinctly vulnerable to further falls against the euro. Global stocks are recovering in line with a return of risk appetite, which favours the single currency. The key driver of the euro also remains firmly in place - Asian sovereign diversification away from the dollar into the euro. With multiple bailouts in recent months and questions hanging over Spanish and Italian debt, and now concerns over German and French economic growth, the resolve of far eastern buyers has been tested but the euro seems destined to remain strong.
We have seen highs up at €1.1550 but this pair is trading back down at €1.1350 at present. In accordance with a weakened outlook for the US dollar, a dip down towards the key EUR/GBP target of 90p, which is equal to €1.1111, seems a decent bet.
GBP/USD
This pair remains true to its longer-term range of $1.59-1.67, with both currencies hemmed in by domestic economic underperformance. There have been some truly alarming US economic figures in recent weeks that have contributed significantly to the decline global stocks. US second quarterly growth undershot expectations (showing 1.0% expansion on an annualized basis) and Philly Fed manufacturing and consumer confidence data slid to levels not seen since the recession.
The Fed has responded by pledging to keep the US interest rate at its current record-low for two years to come, until mid-2013. Speculation of a third round of US quantitative easing has been rife over recent weeks and hopes were high for indications at Bernanke’s Fed press conference and his recent speech at Jackson Hole. The Fed Chairman has held fire on further monetary easing for now but the measure remains very much on the table. If data continues along its current downtrend, then the Fed will have to pull the trigger; many will have their sights set on the Fed’s September meeting. The meeting has been extended to two days, a reflection of the depth of debate surrounding the measures which the Fed is considering in order to stave off another US recession.
The longer-term impact of Standard & Poor’s downgrade of US debt (due to inadequate pledges of spending cuts) should not be underestimated. Looking ahead to next year, if the US government fails to address its fiscal position then further downgrades are likely; Standard & Poor’s has stated as much. The short-term fallout saw sterling fail to sustain a move higher against the dollar in the middle of August, having been rejected at $1.66.
The strength of the EUR/USD rate should keep sterling fairly well-supported against the dollar in coming weeks and months but we do not see any break of this pair’s longer-term range in the current climate. However, if US data does continue to worsen and the Fed does introduce QE3, a break towards $1.70 seems a very good bet indeed. In all likelihood, we may have to look beyond September for the Fed to pull the trigger, and this pair will continue to fluctuate in range in the short-term. An increasingly bearish outlook for the dollar, rather than sterling strength should mean that if there is any direction bias for this pair, it is to the upside from the current $1.62 trading level.
Caxton FX one month forecast:
GBP / EUR 1.12
GBP / USD 1.6350
EUR / USD 1.46
Richard Driver
Senior Analyst – Caxton FX
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