September failed to bring the bounce in global investor confidence and risk appetite that we were anticipating. We have a revised our longer-term forecast for euro strength and dollar weakness due to a sharp deterioration of the global financial environment. Market fears have gone from bad to worse in recent weeks; faith in eurozone officials’ ability to make any real progress on the debt issue is waning and economic data is pointing evermore towards a global economic slowdown. As a result, the equity markets have consolidated early August’s sharp sell-off and the dollar has strengthened significantly. The outlook has probably not looked this gloomy since the last global recession, which favours safe-haven assets considerably.
Perpetual weakness in the US economy, Standard & Poor’s downgrade of US debt and the certainty of ultra-loose Fed monetary policy for the foreseeable future has failed to hold the US dollar back. More pressing global matters have ensured major dollar gains. Added to this, the Swiss National Bank has intervened in the strength of the swiss franc, and the Bank of Japan has been posturing for a similar move, leaving the greenback as the safe haven currency of choice. Sterling is suffering against the dollar accordingly, but has made gains against riskier currencies such as the euro and the commodity currencies.
The euro has really suffered a downward correction over the past five weeks. A Greek default looks inevitable, the European banking system looks vulnerable to a major crisis and a concrete plan to ensure Italy and Spain are not sucked into the eurozone’s bailout cycle remains elusive. On top of this, eurozone growth has slowed to such an extent that a rate cut from the ECB looks is looking increasingly likely at coming meetings.
GBP/EUR
On its own merits, sterling remains an unappealing currency. This is unlikely to change any time soon; economic growth is only teetering above negative territory, which has caused investors to scale back Bank of England interest rate bets to 2013. Indeed, far from tightening monetary policy, the Monetary Policy Committee has pulled the trigger on further quantitative easing (QE2). £75bn in extra asset purchases has been announced in order to boost the UK economy and safeguard it from heightened volatility in the financial markets.
Nonetheless, the eurozone is suffering a comparable slowdown to that of the UK and although the ECB held interest rates at 1.50% this month, there is still a very significant risk of a rate cut in 2011. The debt crisis is clearly impacting activity in the region, as shown by two consecutive months of contraction in the eurozone’s services sector.
Importantly, the UK has maintained its AAA credit rating and is being seen to be ‘doing the right thing’ with regard to reducing its debt. Debt concerns have surrounded the euro all year, with Portugal, Ireland and Greece (for the second time) all seeking aid. However, concerns have reached such heights that the euro has finally borne the brunt of the market’s frustration. There is now a near certainty of some form of Greek default and growing speculation that private investors are going to have to accept a substantial hair cut on their Greek holdings. This has seen the EUR/USD pair decline by over twelve cents from late August’s rate of $1.45.
A key factor weighing on the euro is the inability of EU officials to convince the market that they have any genuine handle on the debt crisis consuming other, larger eurozone states such as Spain and Italy. There is quite clearly lack of any real consensus on any long-term solution, which has brought about the realisation that progress is likely to take months, not weeks. Crucially, Asian sovereign funds seem to be losing their appetite for the euro and have reduced their previously reliable support for the single currency.
Sterling has made some decent gains over the euro in recent weeks then, climbing from a low of €1.13 to trade at its current level two cents higher. We foresee little progress on the debt issue in the near-term, giving the GBP/EUR rate further upside potential. Indeed, the muted market responses to what were anticipated to be significant relief stories, such as the recent German ‘yes’ vote for the expansion of the bailout fund, suggest market sentiment is going to require a really major development to bounce back. Sterling could well edge up by one or two cents from its current trading level of €1.15 in the month ahead.
GBP/USD
The dollar has gone from strength to strength over the past month or so. Safe haven flows have increased as a result of the worsening global economic picture and in addition, the dollar has taken the lion’s share of these safe-haven flows due to the deteriorating appeal of the alternatives (the yen and the swiss franc).
The Fed decided against introducing a QE3 programme last month, instead opting for ‘Operation Twist,’ where by it sells short-term debt and buys long-term debt. The market was unimpressed and thus the dollar remained strong. Still, QE3 remains a possibility in coming months, though it is unlikely that Bernanke will pull the trigger just yet given the slight upturn in the growth data coming out of the US of late. If and when there is further quantitative easing in the US, expect the dollar to weaken off considerably. For this month at least, this looks unlikely.
Sterling has broken out of its long-term trading range against the dollar to the downside. In late August this pair was trading at $1.65, it is now trading at a thirteen month low of $1.53. Sterling has fallen a long way very fast against the dollar, but it is looking vulnerable to a further decline. The pound will continue to struggle against the dollar as long as funds continue to be redirected from the euro to the greenback, which is exactly what we foresee in the coming weeks.
Caxton FX one month forecast:
GBP / EUR: 1.17
GBP / USD: 1.51
EUR / USD: 1.29
Richard Driver
Senior Analyst – Caxton FX
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