June Currency Report
UK outlook improves but sterling still can’t fully capitalise
Whilst sterling has enjoyed itself against commodity currencies like the AUD, NZD and ZAR, it has come under periods of real pressure against majors like the euro and the US dollar. Sterling’s poor performance has not been fully justified in fundamental economic terms, though we can understand why the market’s faith has been dented a little. The market may have been overexcited by the UK economy’s performance in the first quarter (+0.3% GDP) and we have been dealt a few reality checks of late in terms of economic figures. Amid a sharp decline in UK inflation and a lack of change in the MPC voting pattern on QE, sterling has been slapped with fresh waves of speculation that the Bank of England will do further quantitative easing in the months ahead. With Sir Mervyn King heading towards the exit door in the next few weeks, a change to the man at the head of the Bank of England also complicates matters for sterling significantly.
As far as the US dollar is concerned, shifts in speculation as to the US Federal Reserve’s QE3 programme continue to dominate price movement. There really is no other issue that reverberates throughout the financial markets like the QE3 issue and the FX markets are certainly no exception. US economic developments and comments from Fed speakers have ratcheted up the speculation, though there was more than a hint of over-hype about market fears in May of an imminent exit of QE3. The dollar-weakness we have seen in the past few sessions may be a reflection of a market coming to its senses.
Eurozone data showed some brighter spots in May. Q1 GDP figures may have come in significantly softer than expected but Germany is seemingly shaking off some early-year weakness and looks to be stepping up output at the start of Q2. Spain is also stabilising. Tensions with respect to the debt crisis remain remarkably subdued and economic data has taken on the main significance. The euro was unperturbed by the ECB’s decision to cut interest rates and we have even seen a welcome shift in focus from the European Commission towards growth promotion and easing-up on austerity demands. We remain bearish on the euro on a medium and long-term view, but June could be a strong month for the single currency.
GBP/EUR
UK growth kicks on
Sterling has been underperforming for a fortnight now, erasing gains made at the start of the month as a result of some positive Q1 and early-Q2 UK growth figures. April’s manufacturing, construction and services PMI figures all came in above expectation, with the latter showing some particularly encouraging growth. The same has been true of May PMI figures, with the UK services sector coming in at a 14-month high. Provided momentum is carried into June, a Q2 GDP figure of 0.5% is very much on the cards.
Along with some more solid UK unemployment data, the UK outlook really has improved. This hasn’t been lost on Mervyn King and the BoE, the May Quarterly Inflation Report was noticeably upbeat about the UK recovery and Q2 growth in particular. Regardless, sterling’s post-GDP honeymoon was short-lived. But why?
It has by no means been all good news from the UK economy. The latest public borrowing update disappointed, as did the trade balance. The most concerning area has doubtless been the high street. Retail sales data confirmed that April was another shocking month for spending on the high street, with households continuously constrained by alarmingly weak wage growth.
The Carney Factor remains a concern
Another key point of weakness for sterling has been in the area of QE speculation. UK inflation dipped to a seven-month low of 2.4% in May and whilst this remains above the official target, this certainly gives the BoE much greater scope to ease monetary policy via QE. There were plenty of raised eyebrows (us included) with respect to the fact that the minutes for the MPC’s May meeting revealed that despite the brighter UK outlook, three members continued to vote in favour of more QE. We thought the increasingly bullish sounding Mervyn King would at least have changed his vote.
Some softer UK growth figures and the sharp dip in UK inflation would have left sterling vulnerable to more QE regardless but the fact that the market is staring down the barrel of a new BoE Governor has only intensified QE speculation. Mark Carney takes over from Sir Mervyn King in July and some commentators are expecting a monetary policy shake-up, which may or may not involve more QE. There is plenty of scope for more QE if he chooses to make an early impression and this uncertainty has been a major driver of sterling’s underperformance lately and will continue to weigh over the next few weeks.
Green shoots of recovery in the eurozone?
Similar to the UK economy, there has been room for a little optimism with respect to the eurozone. The key development has been the recent upturn in German manufacturing and industrial production data. However, there have been other good news areas; the PMI updates out of Spain and Italy have beaten expectations and there have been some significant improvements in the Spanish labour market over the past couple of months. There is an extremely long way to go and this could well prove premature but some indications have emerged that the eurozone recession is beginning to stabilise.
The ECB cut interest rates last month to a fresh record low of 0.50% and in the subsequent press conference, ECB President Draghi assured the market that he “stands ready to act” if conditions warrant it, be that in the form of another interest rate cut or a move towards negative deposit rates. The growth figures that have emerged since that comment suggest the need to act has receded. One of the key motivations for the rate cut in May was concerns that economic weakness in the eurozone periphery was spreading to the core (Germany), a theme which looks to have abated for the time being. Accordingly, we expect Draghi to focus on boosting SME loans at the monthly meeting this Thursday (June 6), rather than cutting rates.
There is room for further euro optimism this month. On June 11-12, there appears to be a strong chance (according to analysis among the legal profession) that the German Constitutional Court will refer the case of German participation in bailout schemes to the European Court of Justice. Draghi’s bond-buying plan is part of this and it has been crucial in underpinning confidence in the survival of the euro. Referral of the case to the ECJ would appear to be a far safer option in terms of having objections to the bond-buying plan thrown out. This should help to continue keeping the lid on peripheral bond yields for the foreseeable.
We see the euro as pretty overvalued at present. Even when eurozone data outperforms expectations, UK data is still streaks ahead in general. As the UK recovery takes shape, this should be reflected in higher GBP/EUR levels in the second half of the year. However, the softer tone of the USD, the cautious optimism surround the eurozone recovery, and the concerns over BoE monetary policy could be enough to keep GBP/EUR pinned down in the weeks ahead. A dip back down to €1.1630 is perfectly plausible but losses beyond this level should be contained. Broadly speaking, we are looking for more sideways trading in this pair in June, in and around the €1.17-1.18 area.
GBP/USD
Market on red alert vis-a-vis QE3
The USD was rampant for much of May, helped by improvements in US data which have fanned the debate surrounding tapering off QE3. While the US Federal Reserve said in May that it was willing to increase QE3 if needs be, we still think its next move will be to taper things off. So too do most other market players, not least due to an upturn in some key US figures in recent weeks. The latest monthly jobs report was encouraging and improvements in consumer sentiment were particularly impressive. We are expecting another monthly jobs report this Friday (June7). The result has been some increasingly hawkish language from members of the US Federal Reserve.
Still, there remains plenty of reason for caution from Fed doves like Bernanke. This week’s US manufacturing PMI update was the weakest in almost four years and such figures give the Fed ample justification for continuing with QE3 for at least the next few months. US inflation remains very subdued as well, which isn’t conducive to QE3 tapering in the near-term. Expectations of imminent QE3 tapering have been pared back over the past week or so and it’s certainly true that the Fed will be in no hurry. We do think that the move will come about around September/October time.
This should ensure a strong conclusion to 2013 for the USD. US data, while patchy, continues to outperform indicators from the eurozone and the UK on the whole. We see significantly greater risks of another monetary easing move from the ECB and the BoE than we do from the Fed.
A little more room overhead before another downturn
Sterling has benefited from decent support at the $1.50 level and there is some scope for further upward momentum. The recent UK services PMI figure (June 5) has brightened the UK outlook further and a strong EUR/USD pair above $1.30 is also lending plenty of support. A rise to the $1.55 area is feasible in the near-term. However, nerves over QE from incoming BoE Governor Carney will likely dampen any bounce back up close towards the $1.60 level. We remain content with the analysis that this latest bout of USD-weakness is a short-term correction rather than the start of a GBP/USD recovery. The trends in respective economic data and central bank rhetoric from the US and the UK support a GBP/USD move lower in the longer-term. In the meantime, a move to $1.55 is feasible before fresh selling pressure mounts.
Richard Driver
Foreign Exchange Analyst
Caxton FX
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