ECB defers action most likely until the next meeting, Cable is stopped at 1.70 but remains elevated.

UK – The United Kingdom performed well over the last week, as Services PMI came in positively on Tuesday, the Bank of England kept the Asset Purchase Facility and the Official Bank Rate the same on Thursday, and Manufacturing Production m/m came in positively on Friday. The positive economic outlook has supported the pound against most currencies in the last week or so, but depending on the data this week, we could see further gains. The relevant data this week will be Mark Carney holding a press conference on Wednesday, followed by a Bank of England Inflation Report. This will provide the BoE’s projection for economic growth and inflation over the next 2 years. Aside from this data, there will not be any major data releases, so the strength of the pound will largely be determined by market trends and speculation until the press conference on Wednesday.

EUR – The European Central bank decided to keep rates on hold for the moment, which provided a momentary spike of strength for the Euro, until Mario Draghi made a comment at the end of the press conference which strongly hinted at ECB action at its June meeting. His comment was that “the governing council is comfortable with acting next time”. This helped to restore confidence in Draghi’s pledge from June 2012 to do “whatever it takes” to save the Eurozone. However, this undermined the value of the Euro, which dropped around a percent against the Pound and the Dollar. The Euro has started the week out on the back foot, and with little data on the week to change this momentum against the Euro, we could see further losses. The only high-impact event coming out of the Eurozone this week will include German ZEW Economic Sentiment on Tuesday. Aside from this, we expect the rate this week to be driven very much by market sentiment.

USD – In the past week, the dollar index has made a significant gain of around one percent due to some positive data over the last week. There has been a reversal of the downward trend of dollar devaluation since the middle of April, as short positions are beginning to unwind and market sentiment is helping to reverse the losses that the dollar suffered. Data from the US this week could help to support the dollar, as it is forecast to come in more positively. The data will start with Core Retail Sales m/m and Retail Sales m/m on Tuesday, PPI m/m on Wednesday, Core CPI m/m, Unemployment Claims, and the Philly Fed manufacturing Index on Thursday, and finally, Building Permits data and Preliminary University of Michigan Consumer Sentiment data on Friday. With this busy week of US data, we could see the dollar go either way, but the dollar is on the front foot for now.

AUD – The Australian dollar gained against sterling and most other currencies last week, as there was much action from the Australian Central bank. The market has speculated that the RBA will soon cut interest rates, but the central bank kept interest rates at 2.50% at the last meeting, lending strength to the AUD. The Unemployment rate also dropped last Thursday in Australia, and the Monetary Policy report came out suggesting a more hawkish tone than expected, that indicators of the economic outlook are “consistent with the pace of growth”. This was a big week for the Australian dollar and it comes into this week with momentum in its favour.

End of week forecast:

GBP/EUR – 1.2275

GBP/USD – 1.68

EUR/USD – 1.37

GBP/AUD – 1.7980

Nicholas Ebisch

Corporate Account Manager

Caxton FX

Weekly Market Analysis - UK Economic figures drive GBP to gains against most currency pairings, whilst the eurozone takes a more dovish tone following the World Bank and IMF meetings last weekend.

GBP
The UK unemployment rate dropped to a five-year low of 6.9% on Wednesday
which reinforced positive Manufacturing data from a week earlier. GBP/USD rose
to the highest level since 2009 in what is a clear sign of economic confidence
developing in the UK economy. This has put more pressure on the Bank of
England at their next meeting to at least discuss an interest rate rise. However,
there is not a distinct timeline for a rate increase at the moment, as the Bank of
England altered their forward guidance framework last fall to look more broadly
at economic indicators before committing to a more definite timeline. Next week,
the major events on the economic calendar are the MPC Asset Purchase Facility
Votes and MPC Official Bank Rate Votes on Wednesday, followed by the Retail
Sales m/m figures on Friday.

EUR
Mario Draghi stated in New York this last weekend after the IMF and World
Bank meetings that further strengthening of the euro would require additional
ECB intervention because of the low level of inflation in the eurozone. The
international community has overwhelmingly expressed their concern to Draghi
about the low rate of growth in the eurozone and that measures need to be
taken to boost economic growth in the region. Any instability or sign of an
economic decline in the eurozone would have negative ramifications for global
markets because of the eurozone’s central role within the global economy.
Mario Draghi has stated that if further action is taken, it will be an interest rate
cut which precedes further quantitative easing. Draghi is due to speak at a
conference in Amsterdam on Thursday and may provide more clues as to the
further action that the ECB has planned.

USD
The dollar’s performance was weakened over the last week largely thanks
to Janet Yellen making a distinction about the likelihood of an interest rate
rise. During a speech last week, the Federal Reserve chairwoman included
in her comments that there will be a ‘considerable time’ between the end
of Quantitative Easing and the first interest rate rise. This undermined her
comments from the Federal Reserve meeting on March 19th where she said that
an interest rate rise may follow as early as six months after the end of the QE
Programme. The more dovish tone from Yellen has given the Federal Reserve
more breathing room as the Fed continues to voice their concerns about the
sluggish economic recovery, rather than the need for a higher interest rate.

End of Week forecast –

GBP/EUR – 1.2250

GBP/USD – 1.6890

EUR/USD – 1.3770

GBP/AUD – 1.7900

Nicholas Ebisch
Corporate Account Manager
Caxton FX

Conventional and unconventional policies possible from the ECB

The ECB decided to keep interest rates unchanged at 0.25% as expected, but language from ECB President Draghi was dovish and suggested we may see the central bank take action in the next few months. Draghi highlighted the fact that prolonged low inflation itself is a risk, and said the governing council have had a detailed discussion about the possibility of negative position rates. Narrowing the rate corridor and quantitative easing were also measures that were mentioned, with the President claiming QE would need to be designed carefully in order to be effective. Some light was also shed on the strength of the single currency but it was emphasized that any action taken would not be targeted at the exchange rate. Draghi reinforce the fact that he does not see deflation risks in the eurozone, but with these options playing a greater role in ECB meetings, we feel the concern is becoming greater. 

The governing council felt more information was needed about the medium to long term inflation expectations before taking any action, but with different instruments tailored to address various issues it is unclear on what tool exactly the ECB is leaning towards. With the latest reading of 0.5%y/y surprising Draghi, the likelihood of invention in the next few months is increasing.

Sasha Nugent

Currency Analyst

Caxton FX 

October Monthly Outlook: GBP/EUR and GBP/USD

Sterling to benefit from resurgent UK economy

From the eurozone, September’s two key events were ECB President Draghi’s announcement of his long-awaited bond-buying plan and the German Constitutional Court’s decision to approve the permanent bailout fund. Since then, there has been a real lack of any further concrete developments, which has understandably frustrated many market players and caused some risk aversion. As the next major event in the timeline of the eurozone debt crisis, speculation over the imminence of a Spanish bailout request is dominating market thinking at present. PM Rajoy does not actually appear to be much closer to making a formal request; he looks likely to wait until after Spanish regional elections to be held on October 21.

From the US, we have finally seen Ben Bernanke deliver what the market has been waiting for – more support for the US economy in the form of QE3. The move was priced in to a large extent but the dollar has been unable to stage any significant recovery in the immediate aftermath of the Fed’s announcement.

Conditions here in the UK continue to look a little brighter, though understandably many investors will still need further positive evidence to be truly convinced that the economy is on a path to a sustained recovery. However, with the Japanese and US central banks engaging in QE in September and the European Central Bank also taking monetary easing measures of its own (though rather more unconventional), the market is beginning to look more favourably upon the pound again.

GBP/EUR

Spanish delays will hurt the euro

Sterling has made a decent recovery against the euro in recent weeks, after what was quite a sharp decline as a result of the optimism that followed the announcement of the ECB’s bond-buying plan. There has been a positive response to some of the UK figures that have emerged in recent weeks; trade balance data revealed a dramatic rise in exports to destinations outside the EU, suggesting UK businesses are adapting to deteriorating eurozone demand. Meanwhile, UK unemployment figures continue to defy the overall weak picture of UK economic growth by making significant strides. From retail sales data to public sector borrowing figures, the UK economy has been beating market expectations time and again and this is filtering into some sterling strength. Another positive has emerged with the latest upward revision to the UK’s Q2 GDP figure to -0.4%, considerably better than the original estimate of -0.7%. Hopes are high for a very strong showing for the Q3 UK GDP figure released on October 26.

The minutes from the MPC’S September meeting revealed a unanimous vote against further QE (for now). The decision in favour of leaving the BoE 0.5% base rate unchanged was also unanimous. The fact that one MPC policymaker saw a good case for QE in September did not go unnoticed but as things stand, the Bank of England is understandably in wait-and-see mode. In light of the increased room for domestic optimism and the easing of financial conditions in the eurozone in recent weeks, it will not come as much of a surprise to learn that we are not expecting any fresh monetary easing measures from the Bank of England this month. November is likely to see the Bank assess its options much more carefully though.

Coinciding with strong economic figures has been an increased appetite for the pound as a relative safe-haven. Gilt yields have declined in recent sessions as investors attempt to take cover from renewed uncertainties from the eurozone and as usual this has boosted the pound by association. With the QE decisions from the US Federal Reserve and the Bank of Japan in September, sterling has climbed a little higher up many investors’ wish lists in recent weeks.

Putting improved UK conditions to one side, the major factor behind GBP/EUR’s climb in the past month has been a shift in sentiment against the euro, as is predominantly the case when this pair climbs. The market relief that followed the ECB’s commitment to buy unlimited quantities of distressed peripheral debt has well and truly worn off. Investors have refocused on the major issues facing Spain and Greece in particular.

PM Rajoy has thus far snubbed the opportunity to take advantage of the ECB’s offer to purchase Spanish debt, fully aware of the austerity demands that will accompany such intervention. Rajoy is under enormous pressure domestically, with the rich Catalonia region demanding independence and fierce protests taking place in Madrid over existing austerity measures. The market is likely to have to wait until after regional elections held on October 21 for Rajoy to bite the bullet, which leaves a good three weeks of frustration ahead. That said, if rating agency Moody’s cuts Spain’s credit rating to ‘junk’ status, then a spike in Spanish bond yields could force Rajoy’s hand a little sooner.

Greek saga remains volatile

The situation in Greece also remains typically uncertain. October is an important month too, with some chunky bond repayments maturing. Disagreements not only exist between Greece and the Troika (EU, ECB and IMF) but between the IMF and the EU. With the Greek debt profile blown even further off track by a deeper than expected recession, the IMF is now pushing for another Greek debt restructuring in order to get its debt sustainability back on track. Unsurprisingly, more ‘haircuts’ is not at the top of the EU’s list of priorities.

It looks as if there is some consensus over giving Greece an additional two years to meet its targets and the government appears to have been reached an agreement for €13.5bn in additional spending cuts that they hope will unlock the vital next tranche of aid. However, the agreement still needs Troika approval and would need to be approved by the Greek parliament, which amid violent public protests in Athens is no dead cert. Speculation has surrounded the need for a third Greek bailout but this option looks to be a non-starter as it would require parliamentary approval from individual member states. The bottom line is that Greece may well leave the eurozone but EU leaders are unlikely to let this happen while conditions in Spain remain so tense. The pressure for stronger signs of progress will be turned up once again at the next EU Summit on October 18-19.

Sterling has recouped its mid-September losses against the euro and is back trading above the €1.25 level. With market confidence so shaky at present, any concrete progress - most importantly from Spain in the form of a bailout request – will likely give the euro a significant lift. However, our baseline scenario is that this will not occur and that sentiment will continue to weaken towards the euro, helping sterling to build on its domestic economic resurgence and resume its uptrend against the euro.

GBP/USD

Dollar to strengthen despite QE3

The US Federal Reserve finally pulled the trigger on QE3 in September, which meant it was another very soft month for the US dollar. There have been some bright spots amongst US figures in the past month, with trade balance, retail sales and consumer confidence figures all showing some improvements. However, there has been plenty of evidence of continued economic weakness to support Ben Bernanke’s decision to turn the printing presses back on; last month’s key employment update gave little to cheer about. In addition, the final US GDP figure for Q2 was sharply and unexpectedly revised down to 1.3% from 1.7%.

The issues of weak US economic growth and a long period of quantitative easing are by no means at the top of most investors’ list of concerns. The US dollar has strengthened a little in the past fortnight, amid waning euphoria surrounding the QE3 announcement and the ECB’s pledge to purchase peripheral debt. Spain has not asked for a bailout, Greece has not secured its next tranche of aid and growth across the world is slowing. These are all dollar-friendly factors and the slowdowns being seen in China and the eurozone (including Germany) are of particular concern.

Whilst UK growth data has been remarkably positive in recent weeks, the ongoing fragility of the UK recovery has already been highlighted this week by a weaker than expected manufacturing figure. If sterling is to avoid another short-term sell-off against the US dollar, the UK services figure released on October 3 must be firm. However, sterling should get plenty of support in the form of the preliminary Q3 UK GDP figure released on October 26; we are looking for a robust quarterly showing of around +0.6%.

As things stand, sterling is trading almost two cents below September’s 13-month high of $1.63 and we think this high will remain a ceiling for this pair. Regardless of QE3, we see plenty of scope for increased demand for the safe-haven US dollar. We are still anticipating weakness in the EUR/USD pair, which should send GBP/USD back below $1.60 in October. 

Richard Driver

Currency Analyst

Caxton FX

Will the ECB cut interest rates next week?

Away from what’s going on in Spain and Greece, let’s take a look ahead at next week’s ECB meeting. This week’s key German business climate figure was awful and the significance of this will certainly not have been lost on the ECB. With economic contraction throughout the periphery weighing on growth in the eurozone’s powerhouse economy – will the ECB finally put its deeply engrained fear of high inflation to one side and give Germany and perhaps more importantly the rest of the eurozone a helping hand by lowering interest rates?

A German contraction in Q3 is not a certainty but it is now looking likely, particularly in light of the latest German confidence figure, which hit its lowest reading since March 2010. Spain’s central bank warned yesterday that its economy’s GDP continued falling at a “significant rate” in Q3, while S&P forecasted that Spanish GDP will contract by another 1.4% in 2013 and the eurozone economy a whole will achieve zero growth. With conditions so dire in Germany’s major eurozone trading partners, you don’t have to dig too deep to find motivation for a rate cut.

Domestic consumption, which accounts for around 60% of German GDP, is in good shape and consumer confidence remains stable. Admittedly, other domestic German indicators such as the ZEW and PMI surveys also suggested things are not so bad but we can probably put this down to temporary positivity triggered by the ECB’s bond-buying plan. The German business climate survey has built up a strong correlation with German GDP, which leads us to believe a Q3 contraction is on the way. Weak exports are likely to outweigh robust domestic demand.

Still, the ECB seems unlikely to cut interest rates next week. The ECB appears to have already factored in further weakness in eurozone growth; recently projecting a 2012 GDP contraction of between -0.6% and -0.2%. This latest poor figure from Germany probably does little to change the ECB’s approach. Indeed Draghi acknowledged a weaker business cycle in his September ECB Press Conference.

In addition, the ECB’s Nowotny has recently stated that he “sees no need to change interest rates in the eurozone currently.” ECB policymakers have also been lauding the positive response in the financial markets to the ECB’s bond-buying plan, suggesting they are satisfied with the 0.75% interest rate at present. Draghi will also be eager to keep the German ECB policymaker Weidmann on side by waiting until a rate cut is absolutely necessary, when German growth has completely ground to a halt and inflation has eased further. This is likely to happen later on in Q4, perhaps in December. The euro is certainly feeling the pressure at present but it will likely be spared the downside factor a rate cut for the time being.

Richard Driver

Currency Analyst

Caxton FX

Caxton FX Weekly Outlook: Further upside potential for euro

ECB plan triggers euro rally

Mario Draghi alluded to doing “whatever it takes” to save the euro a month or so ago and at last week’s ECB press conference, he outlined just what he meant by that. ‘Super Mario’ as he has been called, revealed a plan that involves the ECB purchasing unlimited amounts of peripheral eurozone nations’ bonds. This has already brought down Spain’s bond yields but as Moody’s has warned today, this does not solve the crisis, it merely buys EU politicians (and not the ECB) the time to address the region’s fiscal and structural shortcomings.

The ball is now effectively in Spain’s court to negotiate acceptable conditions of a bailout that would include ECB intervention in the bond markets. So we are back to the familiar balancing act of Germany extracting sufficient austerity measures without going ‘over the top.’ This could potentially weeks but there is plenty to watch out for in the interim.

Wednesday should bring the German Constitutional Court’s ruling on the legality of the European Stability Mechanism and the eurozone’s fiscal compact. The court is strongly expected to approve both initiatives but a complaint made today by a German MP regarding last week’s ECB bond-buying plan has raised the prospect of another possible delay to the decision, which has ramped up market nerves again.

Wednesday also brings the Netherlands' general election but the euro looks likely to be spared another political saga at this stage, with the latest polls indicating a close race between two pro-Europe parties.

QE3 could finally arrive this week

Going into last Friday’s non-farm payroll figure the chances of the Fed delaying QE3 for the time being were fairly well balanced but it now seems highly likely that Ben Bernanke will at last pull the trigger on Thursday. Ironically, data did reveal that the US unemployment rate did fall to a rate not bettered since January 2009. Unfortunately as the employment change figure revealed, this was not because more jobs has been taken up and will be of little comfort to the Fed. QE3 is priced into a decent extent after Friday’s dollar sell-off but there is every chance we could see another wave of risk appetite give the greenback another knock this week.

Hints of a Q3 rebound for the UK economy

 August’s PMI growth figures from the manufacturing and services sectors were much better than expected last week. In addition, data also revealed that UK manufacturing and industrial production grew at their fastest rates in 10 and 25 years respectively, bouncing back from June’s slump. This summer’s London Olympics also look likely to have made quite a sizeable contribution to the domestic growth, which has caused many to revise up their GDP forecasts for Q3. All this means that QE concerns should not apply any weight to the pound for the next few weeks at least.

Although the euro’s upward climb has stalled today, the prospect of QE3 from the Fed and a positive ruling from the German Constitutional Court could well give the single currency some further strength. This is likely to keep the GBP/EUR pinned close to or even temporarily below the €1.25 level. Against the USD, matters are rather different as the pound currently sits only marginally off a near-fourth month high. Renewed upside potential for the EUR/USD pair could well help the GBP/USD hang on to these gains in the short-term but we continue to expect a reversal in the coming weeks.  

End of week forecast

GBP / EUR	1.2450
GBP / USD	1.6050
EUR / USD	1.2890
GBP / AUD	1.5300

Richard Driver

Currency Analyst

Caxton FX

September Monthly Outlook: GBP/EUR, GBP/USD

August was another strong month for the single currency as the financial markets continued to take comfort in ECB President Draghi’s pledges to do “whatever it takes” to save the euro. There were no major swings among the major pairings, with August typically being a sleepy month where traders and policymakers alike take their summer vacations. Despite a recent upturn in US economic figures, the dollar remains on the back foot, with QE3 speculation more prevalent than ever.

Recent domestic data suggests conditions have improved somewhat in the past month, which gives hope to the market and consumers that the UK economy can yet stage some sort of recovery in the second half of the year. The Bank of England will be content to see how this bounce in activity progresses, so fears of imminent quantitative easing should subside for the time being. Moreover, with a busy calendar for the US and the eurozone in the coming weeks, the UK economy is very much out of the spotlight at present.

The month ahead could well be a pivotal one in the timeline of the eurozone debt crisis. We are seeing the European Central Bank preparing to launch a programme of unlimited bond-purchases as part of a wider bailout package for Spain. The pressure will now build on Spanish PM Rajoy to make the necessary request for help but the conditions Germany pushes for is likely to be subject to tense negotiations.

Next week (September 12) brings the long-awaited decision from the German Constitutional Court on the legality of the European Stability Mechanism and the fiscal compact agreed earlier in the year, around which there is considerably uncertainty. There is also plenty of political risk in the form of a general election in the Netherlands, while the Troika will spend much of September assessing Greece’s attempts to reform before deciding on whether to release the essential next aid tranche. In addition to all these eurozone events, we will learn whether the Fed will finally pull the trigger on QE3 this month.

GBP/EUR

Sterling remains at strong levels against the euro; it is quite clear that the market has spent recent weeks waiting to see how September’s events panned out before punishing the euro any further. Indeed, whilst decisions and concrete actions have yet again been conspicuous by their absence, comments from ECB policymakers and eurozone political leaders have been falling on sympathetic, or rather, hopeful ears. This has fuelled a rebound for the euro.

Signs of life in the UK economy

The UK economy has enjoyed some good news in the past week in the form of some better than expected manufacturing and services sector growth figures, with the latter in particular raising hopes for a recovery. UK unemployment continues to make progress, with the jobless rate falling to an 11-month low of 8.0%. However, the market will need more convincing that the worst of this double-dip recession is behind us before sterling really begins to reap the benefits of improved data. The initial Q2 GDP figure of -0.7% was revised up to -0.5% but confidence is understandably still very fragile. The Bank of England looks content to remain in ‘wait and see’ mode with respect to the need for further QE, so the risks to sterling in this regard are limited for at least the next month.

Will Super Mario save the day?

Positivity surrounding an imminent bond-purchasing plan to deal with soaring Spanish and Italian borrowing costs has been the key feature of the debt crisis in the past few weeks. Timescales as to the launch are immensely tricky to pin down due to the need for Spain to request help from the ECB but the central bank’s fire-fighting measures are likely to be seen a positive for the euro when it does finally come about.

However, these unconventional measures do little to address the fundamental issue at the heart of Spain and Italy’s predicament – their lack of competitiveness. The eurozone periphery cannot bounce back with the euro as overvalued as it continues to be (regardless of the depreciation we have seen this year). Indeed the ECB’s commitment to fire-fighting this summer has exacerbated the situation by strengthening the euro. Crisis management policies like bond-purchases will not see the eurozone through this crisis. We have seen this year that ECB interest rate cuts weaken the euro and for us, it is only a matter of time before the ECB takes this option again, finally putting concerns over inflation to one side. The incentive to cut rates is all too clear; the ECB itself has this week significantly downgraded the eurozone’s growth prospects for both this year and next (possibly as low as -0.6% and -0.4% in 2012 and 2013 respectively).

The ECB and Germany’s opposition to granting the ESM a banking license also continues to stand in the way of any so-called ‘silver-bullet’ solution. Such a move would effectively give the permanent bailout fund unlimited access to ECB funding, eliminating the concerns that linger over inadequate firepower.

Huge risk events ahead in September

The next major obstacle in store is the German Constitution Court’s ruling on whether the new role for the ESM (the permanent bailout fund) and the eurozone’s fiscal compact complies with German law. If it does not, then this would be disastrous for the euro and while the probability is of a positive outcome, the risks to the contrary are significant. September 12 is made all the more important by the Netherlands’’ general election, which has been centred on the issue of the debt crisis. If anti-austerity parties do as well as polls are suggesting, then this is likely to weigh on the single currency.

Concerns over Greece are likely to come to the fore again this month, as the Greek coalition struggles to work through another €11.5bn of spending cuts and as the Troika returns to complete its review of Greece’s efforts to address its fiscal position. A positive Troika report is necessary in October if Greece is to receive its essential next emergency loan, without which it will default and most likely exit the eurozone.

Sterling may well have another slow month against the euro in September as the market prices in a (temporary) resolution to Spain’s crisis. However, we do see this pair resuming its uptrend beyond the short-term, slowly creeping higher towards, though probably falling short of €1.30 by the end of the year. €1.25 should provide plenty of support and we don’t see sterling weakening below this level but equally, provided the German constitutional court give a positive ruling on the ESM and fiscal compact, sterling could well spend much of the coming weeks below €1.2650. 

GBP/USD

Sterling is flying at a 3 ½ month high at present, despite the UK economy’s significant underperformance of its US counterpart. The QE3 issue continues to haunt the US dollar and delay what we continue to believe will be a robust end to the year for the greenback. There is no doubt that the US Federal Reserve has engaged in greater discussion of further monetary accommodation, with several policymakers convinced of the need of QE3. However, Ben Bernanke chose not to utilise his annual Jackson Hole speech to signal another round of QE, though crucially he said nothing to discount it.

Can the US dollar avoid QE3?

It does appear to be a case of ‘when’ not ‘if’ with regard to QE3. The Fed’s reasoning on QE3 seems to have changed from a stance of committing to more QE in the event that the US recovery deteriorates further, to a commitment to QE unless conditions markedly improve. Economic figures out of the US have been somewhat improved in the past few weeks, which may well convince Ben Bernanke to keep his powder dry on September 13. However, there is every chance that Q4 will bring the decision the market is hoping for.

The sounds out of the Bank of England in recent weeks have given the market some reason to look kindly upon the pound. A cut to the BoE’s already record-low interest rate has effectively been discounted and Mervyn King appears content to wait to see the impact of its Funding for Lending Scheme before introducing further quantitative easing. Whether or not more QE comes in November really depends on growth figures in the interim but the latest indicators do suggest a mild upturn.

Nonetheless, we continue to envisage a significant move lower for the EUR/USD pair in the coming months. If this comes about, it will weigh on the GBP/USD pair to a great extent. The euro’s rally against the USD is looking increasingly stretched at current levels of $1.2650 and given that we see this pair below $1.20 by the end of the year, we do expect GBP/USD to retreat significantly from the $1.59 level where it is trading at present. A rate of $1.57 is realistic in the coming few weeks. 

Richard Driver 

Currency Analyst 

Caxton FX

Sterling set for a tough month

As has been the case for many months, eurozone concerns dominated market sentiment in July, so much so that the euro hit fresh multi-month lows across the exchange rates. Immediate concerns over the situation in Spain and Greece hurt confidence significantly, with weak economic growth across the globe adding to concerns. However, market sentiment and the euro have picked up considerably in recent sessions.

After the so-called progress that was made at the June EU Summit, there have been no material developments. The peripheral bond markets are always a good indicator of market tensions with regard to the debt crisis and Spanish 10-year bonds have hit fresh euro-era highs above 7.6% in recent weeks, with equivalent Italian debt setting its own record above the 6.5% level. Whilst economic growth throughout the eurozone is contracting sharply, Spain is edging towards a full-blown bailout and Greece could yet fail to secure its next bailout tranche, which is essential if the country is to avoid collapse.

Economic conditions in the US continue to provide plenty of cause for concern. The US economy slowed from a pace of 2.8% in Q4 2011 to a pace of 1.5% in Q2 2012. Poor performance in the world’s largest economy stunted the US dollar’s progress in recent weeks by increasing speculation that the US Federal Reserve is edging towards introducing the much-debated QE3 measure. However, the Fed’s recent meeting produced yet more ‘wait-and-see’ rhetoric, which has taken some weight off the dollar for the time being.

News out of the UK has also been far from comforting. Recent data has indicated that the domestic economy contracted by 0.7%, which is a shockingly poor figure well below expectations. The Bank of England has introduced another round (£50bn worth) of quantitative easing and the government has initiated an interesting new Funding for Lending Scheme to encourage banks to step up lending, but the effects of these are some way from being felt. In the meantime, UK growth is expected to remain very weak indeed. Sterling still holds some safe-haven demand, though this may be insufficient for it to avoid losses against the euro and dollar this month.

GBP/EUR

Having hit near four-year highs up towards €1.29, this pair has since erased its gains and at the current level of €1.26, it is back where it started in July. Whilst we do maintain that the pound will remain on its longer term uptrend, we anticipate some further short-term sterling softness in the coming weeks.

Spain spooked the markets in July, with borrowing costs soaring well above the 7.0% level amid a request from the Spanish regional government of Valencia’s request for financial aid and concerns of similar emergency needs across Spain’s regions. Spain’s banks have already agreed a bailout with international creditors and it has certainly discussed a full-blown sovereign bailout with Germany, which continues to demonstrate growing bailout-fatigue. In terms of austerity and economic reforms, PM Rajoy is doing all he can but investors are still hammering Spain in the bond markets. A sovereign bailout is looking increasingly unavoidable.

Last week’s ECB meeting was the most eagerly-awaited in a very long time but the market was left wondering what could have been. Draghi had a plethora of options available to him and after he stated that he would do “whatever it takes” to preserve the euro, he delayed any action whatsoever. The decision not to cut interest rates was unanimous after June’s 0.25% reduction, despite ECB President Draghi predicting that the eurozone economy is likely to recover only very gradually, whilst noting significant risks to further deterioration. Q2 was an awful one for the eurozone, with weakness in the periphery spreading to core states including Germany. The latest German and French manufacturing figures reveal a sharp contraction and eurozone unemployment remains a major issue, having recently reached a fresh record high of 11.2%.

Draghi disappointed the markets by suggesting that the European Stability Mechanism will not be granted a banking license, which had been previously indicated by an ECB policymaker and would have greatly increased the bailout funds’ firepower. Importantly, Draghi indicated that the ECB may move to buy up peripheral debt to ease pressure in the bond markets, but his comments fell short of a pre-commitment, never mind concrete action. German resistance to ECB bond-buying and demands for fiscal restraints represent a key obstacle to ECB emergency action.

Whilst alarm bells ring in the eurozone, the UK economy is also in a very weak state, which is best demonstrated by the recent-0.7% GDP figure from Q2, leaving the UK economy firmly in recession. Initial signs have not been positive for Q3 either; the UK manufacturing sector posted its worst figure in three years and the UK services sector gave its worst showing in eighteen months in July.

The Bank of England is clearly concerned with economic conditions in the UK, having introduced another round of quantitative easing in July to support the economy. The MPC voted 7-2 in favour of the £50bn top-up and there were suspicions that another dose would be approved at its recent August meeting in response to the latest shock GDP figure, though sterling has been spared this development. The government has also taken its own action to try to drag the UK out of recession in the form of its Funding for Lending initiative, designed to incentivise UK banks to increase lending, something that the Project Merlin initiative failed to do.

It needn’t be all pessimism towards the UK economy; there remains some fairly strong scepticism over the reliability of the awful initial Q2 UK GDP figure and in combination with the improved weather conditions, hopes for a significantly stronger second half of the year are not misplaced. The effects of the additional round of QE, the Funding for Lending programme should help the UK return to growth, though this may have to wait until Q4. Unfortunately though, initial expectations that the London Olympics will add 0.5% to UK GDP this year are receding.

The sharper than expected recession has highlighted the question marks over the UK’s treasured AAA credit rating. Rating agency Moody’s has retained its negative outlook for the UK’s credit rating, though fears have been quelled somewhat by Standard & Poor’s recent reaffirmation of the UK’s top rating with a stable outlook.

Sterling is trading at €1.26 at present, which represents a pretty aggressive decline from its multi-year high of €1.2878. With weak UK growth figures set to flow this month, we expect this rate to retrace further in the coming weeks down to €1.25. There is a risk that this pair will revisit its June lows of €1.2270 but on balance we think this is unlikely.

GBP/USD

Sterling has remained range-bound against the US dollar over the past month, fluctuating between $1.54 and $1.57. The news out of the US economy has broadly been very disappointing; June’s labour figures were alarmingly poor, manufacturing data was shaky and retail sales contracted sharply. In addition, the US economic growth rate of 1.9% (annualised) in Q1 slowed down to 1.5% in Q2 - almost half of the rate we were seeing at the end of last year.

Naturally, weak growth figures saw bets on QE3 ramped up yet again, which has been a thorn in the US dollar’s side for some time now. Ben Bernanke disappointed the market yet again in his July US Federal Reserve Press Conference. There was no QE3 announcement, nor any real signals that a move is imminent. Clearly this is good news for the US dollar, if not for global market confidence.

The recent release of July’s US non-farm payrolls figure should free up the US dollar to make some gains this month. Data revealed that 163 thousand jobs were added to the payrolls in July, which represents the best showing in five months and should ease fears of a sharp slowdown in the US for now. One thing is certain though, QE3 will remain very much on the Fed’s list of options for the foreseeable future. We see the Fed pulling the trigger on QE3 at some point in Q4.

Despite Moody’s recent reaffirmation of the UK’s AAA credit rating, market confidence in the pound appears to be waning thanks to a steady flow of weak UK growth figures. More of the same can be expected this month and to make matters worse, anecdotal evidence suggests the Olympics will fail to provide the economic boost that was initially expected. The Bank of England held off from adding another dose of QE at its July meeting but suspicions of another top-up will grow with every negative piece of UK data.

We hold a negative view of the EUR/USD pair in the coming weeks, based on continued uncertainty on all fronts; sharp contraction in eurozone growth, a possible Spanish bailout, Greek uncertainty and a continued imbalance between talk and genuine action. If EUR/USD heads down towards $1.21 as we expect, then this would almost ensure GBP/USD declines even if UK news is positive. Given that we expect news out of the UK to be negative, we feel this pair’s downturn could be quite aggressive. A move down $1.52 looks realistic in the coming weeks.

Richard Driver

Analyst – Caxton FX
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ECB President Draghi calms market fears by pledging the ECB will do “whatever it takes”

The president of the European Central Bank, Mario Draghi, has asserted this morning that, within its mandate, “the ECB is ready to do whatever it takes to preserve the euro, and believe me, it will be enough.” He added that the solution was “more Europe,” which again was music to the market's ears. Unsurprisingly, the euro has rallied on Draghi’s positive comments; EUR/USD has bounced by almost two cents.

These comments build on the relief story that was delivered yesterday by ECB policymaker Nowotny. Nowotny indicated that the European Stability Mechanism could be granted a banking license, which would in turn increase its lending capacity. The eurozone’s inadequate ‘firewall’ has long been a major gripe of investors and the fact that there are members within the ECB looking to address this was greeted with open arms. It goes without saying that Nowotny’s comments are a long, long way from becoming policy and he will certainly meet some stiff opposition within the central bank.

This week’s jawboning really ramps up the pressure on the ECB to deliver some emergency policy response of note at its monthly meeting next Thursday. If it fails to deliver a convincing plan on how to bring down Spanish and Italian bond yields which are threatening to force both countries into bailout territory, the euro is likely to come under some fresh and considerable selling pressure. Restarting the ECB’s bond-buying programme, which has been on hold for several months, would be welcomed enthusiastically, as would quantitative easing. Some action will surely come next week, as the ECB is forced to fill the policy vacuum left by the EU’s dithering politicians.

Richard Driver
Analyst – Caxton FX
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Interest rate cut seems inevitable as the ECB looks to ease the debt crisis

The Governing council meeting of the ECB is set to meet in Frankfurt on Thursday and it is widely expected that it will produce the decision to lower its interest rate. It is a measure of the eurozone’s poor debt and growth dynamics that the ECB interest rate has already been cut to its current record low 1.00% level from its August 2008 level of 4.25%.

Clear indications have been made that the ECB is looking to cut the base rate. ECB Chief Economist Peter Praet has stated in the past week that “there is no doctrine that interest rates cannot fall below 1 percent…they (rate cuts) are justified if they contribute to guaranteeing price stability in the medium term." These comments followed others from another ECB policymaker who stated that a rate cut was an option that would be discussed in its July meeting. In light of this rhetoric, the market is rightly confident that another emergency cut will come from the ECB on Thursday.

A rate cut should come as no surprise given the prevailing conditions in the eurozone. Data this week has revealed that eurozone unemployment has hit its highest ever level of 11.1%. Growth data from the eurozone, including Germany worryingly, has been consistently poor and it is quite clear that the region had re-entered negative growth. Q2 could actually prove to be the worst quarterly growth performance in three years.

Eurozone inflation has also eased significantly this year, falling to 2.4% from the 3.0% level at which it ended 2011. Germany has always been obsessed with controlling inflation but even it must have softened its stance on loose monetary policy in light of the news that its domestic inflation rate eased more than expected to 1.7% last week.

There are plenty of doubts surrounding the impact of another interest rate cut. The Bank of England has decided not to cut interest rates despite entering a double-dip recession, precisely because of the limited impact that such a move would yield. However, a rate cut would translate into significant savings on the huge amount of loans that European banks have taken from the ECB over the last year.

There is the argument that a rate cut will actually undermine confidence as the ECB is seen to be desperately exhausting its options, but we reject this. Our view is that a rate cut will actually be welcomed as a piece of assertive action amid growing eurozone turmoil, though the reduction of the euro’s interest rate differential will stop this boost in confidence resulting in any material support for the euro.

It goes without saying that a rate cut will not solve the problem in the long term. The financial crisis in the Eurozone has come about due to structural problems, and as such, the solution must involve structural change. Lowering interest rates is not capable of fixing this crisis. In fact as ECB President Draghi has noted, long-term solutions to the debt crisis are in the hands of the EU’s political leaders, not its central bankers. The ECB can only really ease conditions in the short-term, as shown by the two rounds of cheap loan offerings in the past year or so (LTROs).

There are differing views on just how much Draghi & Co will cut the base rate by and the size of the cut is likely to impact on the market response. A 0.25% rate cut may not be enough to satisfy the market’s appetite for emergency measures. A 0.50% cut is possible but a quarter percent cut seems more likely, with the ECB declining the options of another cheap loan offering or bond-buying.

Adam Highfield
Analyst – Caxton FX
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