The euro and other risky currencies continued on their uptrend in February, spurred on by the ongoing impact of the European Central Bank’s (ECB) mid-December LTRO (cheap loan offering), further improvements to the US economic recovery and the emergence of a Greek bailout agreement.
The ECB’s cheap loans have ensured that credit conditions in Europe have eased this year and have fuelled a rally in eurozone bonds. A long-awaited Greek bailout agreement finally arrived in February, quelling fears of a messy Greek default in mid-March.
However, huge uncertainties surround both the Greek and wider eurozone debt situation. In addition, data this year clearly points to the onset of a recession in the euro-area. Asian and Middle-East sovereigns are nonetheless sticking by the euro and persisting with their project of diversifying their FX reserves away from the US dollar.
UK growth data continued on its uptrend in February, with the UK services, manufacturing and in particular, the retail sector, finding some much-needed traction. The Bank of England’s (BoE) Quarterly Inflation Report gave sterling a lift by increasing its long-term forecasts for UK inflation.
A UK interest rate rise remains a long way off- probably at least two years - but a higher inflation projection reduces the Monetary Policy Committee’s (MPC) incentive to introduce further UK quantitative easing (QE). However, this was not enough to stop two MPC policymakers from voting for £75bn, rather than the £50bn that was decided, of additional QE in February, a factor which hurt the GBP/EUR rate in particular last month.
GBP/EUR
Sterling has found it hard going against the euro in recent weeks, stalling at the €1.21 level and subsequently falling three cents (though it has since recovered to trade at €1.1950). The relief that Greece finally managed to break the deadlock and reach a bailout agreement helped the euro.
Consequently, leading stock indices such as the S&P 500 and the FTSE 100 are not far off four-year highs. 10-year bond yields in key eurozone states like Italy and Spain have come back down to a far more comfortable level of 5.0%, thanks largely to the ECB’s LTRO action, and confidence and risk appetite has largely been on the up, which rarely benefits the pound against the riskier euro.
Still, we are confident that the euro will continue to be dogged by negative eurozone headlines throughout this year. The fact that Ireland recently announced it will hold a referendum on the EU fiscal compact agreed in January highlights the scope for delay, market nerves and potential U-turns with regard to long-term political progress on the eurozone debt issue.
Another eurozone frustration is the ongoing wrangling over the expansion of the eurozone’s bailout resources. The current firewall is inadequate to deal with crises in Spain and Italy and it has been made clear that eurozone members must stump up more cash before the IMF makes more funds available. A lack of leadership in the EU will inevitably filter into diminished appetite for the euro.
Furthermore, the Greek situation is far from resolved, despite its recent bailout agreement. In the short-term, Greece still hasn’t reached a firm deal with its private sector creditors on a debt-swap. If the Greek collective-action clause is activated, which will occur if 90% of Greece’s creditors fail to participate in the proposed debt-swap, then the deal would cease to be classed as voluntary and credit default swaps would be triggered, which would likely result in another wave of financial turmoil.
Debt issues aside, the eurozone’s growth outlook also points to weaker sentiment towards the single currency. Whilst the ECB seems satisfied with leaving the eurozone interest rate at 1.00%, instead focusing on monetary easing via the €1trn of cheap loans it has granted in the past three months, the likelihood is that the eurozone as a whole is set to enter a prolonged recession. Data has revealed that the eurozone economy contracted by 0.3% last quarter and PMI data from February suggests Q1 will be little better. That said, one bright spot for the euro has been some improved forward-looking German business and consumer confidence surveys but risks remain to the downside.
As far as the UK economy is concerned, growth data has continued to pick up in the past month, best demonstrated by the strongest monthly retail figure since last April’s Royal Wedding. Despite the familiar and ongoing risks coming from the eurozone, the UK is looking increasingly likely to avoid another quarter of negative growth, which would take it into a technical recession. The BoE added another £50bn to its QE programme last month but the move was fully priced in and sterling weathered the announcement pretty well.
Judging by less dovish comments from Mervyn King of late and the BoE’s recent Quarterly Inflation Report, February’s QE move should be the last of its kind this year, even though MPC policymakers, Posen and Miles, put the market on edge with votes for £75bn.
The most significant risk to sterling continues to be posed by the credit rating agencies. Moody’s put the UK on a negative outlook in February; a loss of the UK’s prized AAA rating is a major pillar of support for the pound and its loss would be very damaging indeed.
Growth will not continue on its current trajectory this year, but the most important thing is that the UK doesn’t slip back into recession. Government borrowing figures improved last month, which should keep debt downgrade fears at bay for now. On balance, we are still betting a double-dip will be avoided in the UK.
€1.18 provided ample support in late February and sterling has since rallied to €1.1950. Largely due to the plethora of risk events that lie ahead in the eurozone, as well as the euro’s rally running out of steam of late, we are looking for a stronger GBP/EUR pairing in the coming weeks and months, which should see it revisit January’s multi month highs above €1.21 in March.
GBP/USD
After a couple of dips below $1.57, sterling has gone from strength to strength in the past week or so. In contrast, the US dollar has seen weak demand this year, amid pretty positive trading conditions; the dollar is always likely to struggle amid rising equity prices. Data from the US economy has played a key role in the improved sentiment within the financial markets.
February’s key monthly US unemployment figure improved for the fourth consecutive month to post a nine-month high. The US manufacturing and services sectors also provided further scope for optimism, as has the recent upward revision of US GDP for Q4 of 2011, which revealed an annualised growth rate of 3.0%.
The steady flow of improved US figures seems to have taken the US Federal Reserve by surprise. Fed Chairman, Ben Bernanke, caused a major stir in the currency markets this week by omitting any references to QE3 in his speech. Instead, he cited improvements to the US economic performance, particularly within the US labour sector. Whilst the Fed has made it clear that it doesn’t anticipate raising interest rates until late 2014, a US outlook with no more quantitative easing is a distinct positive for the US dollar.
It has certainly been a relief to see UK growth pick up in the past few weeks. Whilst it is outperforming its eurozone counterparts, the US economy is the frontrunner and its 2012 outlook is significantly brighter. The UK’s vulnerability to a sharp eurozone downturn outweighs that of the US, which should again favour the dollar as investors assess their options.
In the event that UK growth does run out of steam, QE and debt downgrade speculation will certainly resurface to the detriment of sterling. QE will not be a concern with regard to the US dollar any more, while it has already demonstrated it can withstand a debt downgrade as it did last summer (when S&P cut United States’ AAA rating). These are perhaps longer-term considerations but will doubtless come to the fore in coming months.
We see downside risks to the eurozone situation resulting in a downward correction in global stocks and increased safe-haven flows into the US dollar soon. Asian and Middle Eastern sovereigns are continuing to diversify out of the US dollar into the euro but even this should not be enough to prop the euro up at these levels this year.
We are looking for a major reversal in the EUR/USD pairing, which points to a firmer USD moving forward. This will inevitably weigh on the GBP/USD pairing. In the short-term, we may see sterling make one last charge at $1.60 (which it currently trades marginally below) and beyond, an attempt at $1.61. However, we are looking for GBP/USD to reverse most of its recent gains in the medium term, correcting back down towards $1.57.
Caxton FX one month forecast:
GBP / EUR 1.2150
GBP / USD 1.57
EUR / USD 1.2950
Richard Driver
Analyst – Caxton FX
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