The perpetual threat to the global financial system that is Greece has dominated the headlines in recent weeks. The country’s May 6th elections saw the ruling pro-bailout coalition fail to secure sufficient support from Greece’s angry electorate. This ushered in a month of huge uncertainty as the market looked ahead to another Greek election on June 17th; with speculation growing that Greece’s anti-bailout parties would curry enough favour to form a coalition. The logical result of a rejection of Greece’s second bailout agreement would be default and an exit from the euro, so it should come as no surprise that the euro suffered further declines.
The pound was a key beneficiary of these euro declines, despite the negative implications that the eurozone debt crisis has on the already dire state of the UK economy. Recent data not only confirmed that the UK entered a double-dip recession in Q1, but it contracted by 0.3% rather than the 0.2% initially estimated. Taken with April and May’s growth figures, which are pointing to a soft start to Q2, this has unsurprisingly triggered fresh speculation that the MPC will edge back towards introducing more quantitative easing in the second half of the year. We are doubtful in this regard, for now.
Sterling is trading at impressive levels against the euro and despite a period of profit-taking in the past week or so, it remains at strong levels against the majority of global currencies thanks to its safe-haven, euro-alternative tag. However, as usual there is one currency sterling can’t outperform in the strongly risk averse trading conditions that characterised most of May – the US dollar. The dollar has helped itself to some easy and significant gains across the board as the eurozone debt crisis forces market players to unwind their riskier positions in favour of the safest of assets.
GBP/EUR
Sterling remains firm and continues to threaten higher climbs against the euro, as conditions in the eurozone go from bad to worse. Uncertainty, as ever, is the buzz word. The pro-bailout New Democracy Party has edged ahead in the Greek opinion polls, which has lifted market hopes that the country can receive the additional funding it needs and remain ‘safely’ within the eurozone. But there is plenty more debate to be had in Greece and few will be truly confident of a positive result ahead of the fresh elections on June 17th. Yet another Greek election is a distinct possibility.
The chances of a messy ending to the Greek saga remain very high. Even if a pro-austerity, pro-bailout coalition does emerge out of this month’s elections, they will still have to find a way to deliver the major reforms and deficit reduction that the country’s €130bn bailout agreement requires – no mean feat. The EU Commission has recently reminded Greece that its bailout payments remain highly contingent but whoever wins this month’s elections, you can expect some desperate efforts to have the bailout terms relaxed to a significant degree.
Spain rings alarm bells
Greek concerns, though likely to return to the fore as the elections draw closer, have been put on the back burner for the time-being. True to form, another struggling eurozone nation has stepped up to fill the void – Spain, or more specifically, Spain’s banking sector. Bankia, Spain’s fourth-largest bank, requires €19bn worth of recapitalisation and it is becoming more and more apparent that Spain will need help to shore up its banking sector as a whole. The issue is having a significant impact on Spain’s government borrowing costs, with 10-year bond yields climbing dangerously towards the unsustainable 7.0% level.
As ever with this debt crisis, market fears build so much that they tend to become a self-fulfilling prophecy. In short, Spain is in very serious trouble and its government has admitted as much – requesting EU help with bank capitalisation. This is no minor development given that Spain is the eurozone’s fourth-largest economy and emergency help for Spain will inevitably turn the market’s gaze towards the third-largest – Italy.
UK economy still looks frail
The UK economy is looking particularly downbeat at present, having been hit with the confirmation that it is firmly in double-dip recession territory. Unsurprisingly, consumer confidence has taken a sharp downturn and weakness in UK growth figures has become alarmingly consistent. The last update from the UK labour market was a little more encouraging but we will need to see more than one good month before hoping for sustained improvements.
Amid all of this bad domestic economic news, as well as the grave threats posed by the eurozone debt crisis, it might be assumed that more quantitative easing is bound to be introduced by the Bank of England in order to drag the UK out of recession. Certainly the IMF has made its views known on the issue, encouraging the BoE to act soon to safeguard the UK economy.
However, the noises out of the MPC have not suggested that such a move is imminent, despite the recent sharp decline UK inflation from 3.5% to 3.0%. A key reason for this is that the BoE sees UK inflation in the medium term as equally likely to exceed its 2.0% target as undershoot it. In addition, Spencer Dale has recently stressed the argument that the recent quantitative easing doses are still feeding through to provide stimulus and that a further round is not appropriate at present. This position is supported by the recent improvement in UK money growth.
With only one MPC policymaker voting in favour of QE at the MPC’s May meeting, in the form of David Miles, there is plenty of dovish recruitment to be done in the coming months if the BoE is to pull the trigger again on further monetary easing. Sterling seems safe in this regard for June at least, though eurozone risks could feasibly escalate sufficiently to prompt BoE action in July or August.
Euro to weaken further
So, despite the UK economy sitting uncomfortably in a double-dip recession and facing a prolonged period of stagnant growth and ultra-low interest rates, sterling looks free to continue taking advantage of an increasingly euro-negative environment. Some major steps towards EU fiscal union will be required to ease market sentiment, and the obstacles to this are all too clear.
Sterling/euro hit heights of €1.2575 in mid-May but has come off those highs to the current level of €1.24. We envisage further gains for the relative safe-haven pound in June, with the Greek elections and rising Spanish bond yields providing plenty of motivation to exit the euro. €1.26 is a realistic target in the coming few weeks.
GBP/USD
Whilst sterling has enjoyed something of an easy ride against the troubled euro, against the US dollar it has been an altogether different story. Again, market uncertainty best explains the US dollar’s stellar performance in May. It’s fair to say that the market is in a state of panic at the moment, concerned with a ‘Grexit’ and most recently a ‘Spexit.’ Amid such monster question marks, there has been widespread flight to the safest assets such as the US dollar. Sterling may be markedly a safer alternative to the single currency, but its safe-haven status cannot compare with that of the greenback.
The rug has finally been pulled from underneath the EUR/USD pair. The scale of the eurozone’s current problems is now being reflected in the price of the euro; EUR/USD has declined by over 5.0% from $1.3150 to $1.25 in the space of just one month. We do see the EUR/USD pair considerably lower in the coming months, which will inevitably weigh on the GBP/USD pair.
The US dollar is not without its own domestic economic concerns, with recent data confirming that the US economy grew at an annualised pace of 1.9% in Q1, down from the initial estimate of 2.2% and well down from Q4 2011’s 3.0% pace of growth. Progress in the US labour market has also slowed right down, which has once again seen speculation that the US Federal Reserve will introduce QE3 step up a gear. Whilst the US economy is stalling as we enter the summer, it is still firmly in recovery mode. We continue to hold the view that the Fed will want to gather more evidence about the US recovery’s direction before pulling the trigger on more quantitative easing, so we view the current QE3 concerns as over-hyped.
Safe-haven dollar to outperform
Sterling has recently revisited January’s lows below $1.53, having suffered a 6.5% drop against the US dollar in the space of just four and a half weeks. Sterling has finally bounced against the US dollar and is currently trading at $1.55, but we think this will prove temporary. A consolidation period was always likely after such a steep drop, but we should see lower levels tested once this current bout of profit-taking on the dollar’s recent rally has run its course. Lower levels in the $1.51-1.52 area could well be seen in June as the negative eurozone headlines once again take their toll.
Caxton FX one month forecast:
GBP / EUR : 1.26
GBP / USD : 1.5150
EUR / USD : 1.2050
Richard Driver
Analyst – Caxton FX
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