Sterling has performed excellently in the past month, hitting fresh multi-month highs almost across the board. Some notably less dovish Monetary Policy Committee (MPC) minutes provided the trigger for a sterling rally in April, with the market subsequently betting against the likelihood of further Bank of England (BoE) quantitative easing (QE) - a key factor which has weighed on the pound over the past seven months.
The Office of National Statistics (ONS) last week announced the disappointing news that the UK economy contracted by 0.2% in the first three months of 2012. Taken with Q4 2011’s 0.1% contraction, this latest GDP figure signalled the UK having entered a technical recession. Nonetheless, sterling continues to enjoy strong demand as circumstances worsen on the continent.
The US dollar is still struggling to capitalise on its economy’s comparative strength. US growth data has fallen off its impressive uptrend somewhat, as shown by April’s softer unemployment figures and the recent undershoot in the first quarter US GDP figure.
This has played into the hands of the more cautious members of the US Federal Reserve, including Chairman Ben Bernanke, who refuse to rule out the possibility of another round of US quantitative easing. The market is becoming increasingly obsessed with the Fed’s monetary policy outlook and ongoing QE3 speculation continues to hurt the dollar’s performance.
The eurozone’s debt and growth situation is looking no better and worryingly, perhaps as a result of this lack of progress, the eurozone has become embroiled in fresh political uncertainty. French President Nicholas Sarkozy, could well suffer electoral defeat on the 6 May, whilst Greece will be holding parliamentary elections on the same date. Both elections could have significant ramifications on the direction of eurozone debt crisis in the short and long-term.
GBP/EUR
April saw sterling finally break away from the €1.21 level that had proven so sticky in the year to date. News out of the eurozone has been distinctly negative of late but unusually, the latest direction in this pair wasn’t predominantly euro-driven, but the result of much-improved sentiment towards the pound.
Economically, the situation in the UK remains extremely shaky. While April’s growth figures from the manufacturing, construction and services sectors were all encouraging and retail sales growth was staggeringly strong, the UK GDP figure for Q1 revealed a disappointing 0.2% contraction.
The market appears to be more than a little sceptical with regard to the ONS’s findings and will be looking for an upward revision to the GDP figure on 24 May. Regardless, the headlines surrounding a ‘double-dip recession’ are likely to weigh on consumer and business confidence alike.
UK suffers the double-dip
Whether or not the UK is indeed in a technical recession, UK growth will remain extremely weak in 2012. Disappointingly, Moody’s has recently placed doubt over the likelihood of any economic boost to the UK as a result of the London Olympics in the summer. The eurozone crisis continues to pose the greatest risk to the UK economy. As shown by the latest UK manufacturing figures, export orders are slowing and the eurozone’s economic contraction will undoubtedly drag on domestic activity.
The good news for sterling, however, is that its appeal is not based on economic growth potential. Sterling still represents a convenient alternative to investors looking to exit the euro but stay within Europe. Sterling is also a currency over which there is no threat of intervention looming (unlike the Japanese yen and the Swiss franc).
Despite the recent double-dip headlines, the UK government has reiterated its commitment to the austerity path, in order to maintain the faith of both the credit rating agencies and investors, thus keeping borrowing costs low. As a result, sterling’s ‘second tier’ safe-haven status has really come to the fore in the past few weeks and will provide plenty of support as the debt crisis rolls on.
MPC steps away from QE
Most importantly, sterling is now a currency over which there is perceived to be a reduced threat of quantitative easing, which contrasts particularly with the US dollar. The minutes from the MPC’s April meeting revealed that Adam Posen did not vote for additional QE, which took the market very much by surprise and left only David Miles as the solitary voter for additional monetary easing.
After a slight increase in UK inflation up to 3.5% in March, the MPC increased its medium-term inflation projections. The MPC’s apparent preoccupation with UK price pressures, over and above the state of UK growth, has seen bets on the likelihood of further QE from the BoE scaled back. With the MPC likely to remain in wait and see mode’ at its May meeting on 10 May, the pound has gone from strength to strength. Beyond this month though, there remain significant risks that the more pro-QE arguments will resurface to haunt the pound.
Downside risks to the euro
With regard to the single currency, events in the eurozone over recent weeks have certainly weighed on confidence, though not as much as one might expect. Growth data from Germany, France and the eurozone as a whole disappointed in April and another quarterly contraction is likely to be announced on 15 May. This will put the eurozone in the same boat as the UK - in technical recession. However, there’s no doubt the eurozone faces greater downside risks to growth than the UK moving forward and its recession is almost certain to continue through Q2.
Last month’s Spring IMF meeting failed to convince the markets that EU leaders have a proper handle on the EU’s ongoing crisis. The region’s ‘financial firewall’ has been bolstered by a further $430bn, which is a significant development. However, rating agency S&P has recently seen fit to downgrade eleven Spanish banks, which has seen Spanish and Italian 10-year bond yields make their way back up towards the dangerous 6.00% mark -a good bellwether of rising market tensions.
These rising tensions can largely be put down to fresh political concerns. 6 May brings the second and final round of the French presidential election. Nicholas Sarkozy is facing a likely defeat by Socialist candidate Francois Hollande, which places huge uncertainty over the EU’s Franco-German leadership, the EU’s fiscal compact and its ‘austerity first’ position.
Meanwhile in Greece, parliamentary elections threaten to prevent the country’s two leading pro-bailout parties from securing a majority, which again casts uncertainty over Greece’s bailout situation. In addition, the Dutch government’s collapse as a result of disagreements over austerity measures is telling of a growing political discontent across the region. There is a significant risk that the austerity backlash could spread to the UK local elections this week but the government is nonetheless unlikely to be derailed on its commitment to deficit-reduction.
GBP/EUR has climbed by over 2.50% in the past month, hitting fresh multi-month highs up to this week’s peak above €1.23 (the highest since July 2010). We are looking for further gains in the rate as conditions in the eurozone continue to deteriorate, with the €1.25 (80p) level representing the first key target.
GBP/USD
The US dollar remained soft in April, hemmed in by weaker US economic data and ongoing dovish rhetoric from US Federal Reserve Chairman Ben Bernanke. The monthly US jobs figure for March revealed that half as many jobs were added to the payrolls compared to February and US GDP data for the first quarter of 2012 came in at a disappointing 2.2% (annualised), against expectations of a 2.6% reading. Clearly the US economy is recovering at a far stronger pace than what we are seeing in the UK but it is the implications that this slower pace of growth (the US economy grew at a pace of 3.0% in Q4 2011) has with regard to the US Federal Reserve monetary policy.
The Fed was slightly brighter in its analysis of the US economy last month but is highly likely to remain in ‘wait and see mode’ for the foreseeable future. Bernanke has repeatedly put the brakes on any over-optimistic projections of US growth and has reminded the market that if the pace of US growth softens further from its current moderate pace and progress on the labour market issue stagnates, then QE3 is still very much on the table. Every time Bernanke emphasises the possibilities of QE3, the dollar sells off as risk appetite is boosted and investors chase higher yielding assets, such as the Australian dollar or stocks and shares.
The US dollar has found some favour in the past couple of sessions, helped by a stronger US manufacturing figure. However, a slide in the EUR/USD pair as a result of poor growth figures from the eurozone (Italy in particular) has proven more influential.
It has been difficult calling a top to the GBP/USD’s recent rally in the year to date. It must be said that with the recent poor UK growth figures in mind, doubts are likely to creep in with regard to the likelihood that the MPC will resist further QE this year. This may make this pair’s 8-month high of $1.63 a tough level to breach. We continue to anticipate that EUR/USD will fall through the $1.30 threshold this quarter and whilst sterling should hold up better against the dollar by comparison, a significant decline remains likely. Therefore, we are anticipating GBP/USD to ease back towards the $1.60 level, from the current rate below $1.62.
Richard Driver
Currency Analyst
Caxton FX
