Caxton FX Weekly Outlook: UK GDP needs to be firm

Sterling kept out in the cold despite host of strong UK figures

It was a good news week as far as the UK economy was concerned last week. We saw some more positive UK labour data; the unemployment rate dropped 7.9%, which is the lowest seen in over a year. Meanwhile, there were four thousand less jobless claimants; the improvements being seen in the domestic labour market are being sustained far beyond what many had expected.

UK retail sales data was also stronger than expected last week, while the public sector net borrowing figure also revealed that the government borrowed the least in the month of September since 2008. The chances are that Osborne will still miss his deficit-reduction targets but things appear not to be as bad as once feared.

Another development last week, which should have been positive for the pound, was a rather less dovish MPC minutes than expected. There appears to be a clear dovish voice within the MPC, led by David Miles, but there is no doubt that there are plenty in the nine-member committee who doubt that the UK economy needs a further dose of quantitative easing. Better still for the pound was the skepticism of some MPC members that more QE would actually be of any real practical benefit. Mervyn King speaks this evening and will perhaps provide some further clues. UK inflation has dropped to almost a three-year low, which is not exactly supportive of the pound but it was quite surprising to see the market ignore last week’s slew of genuinely upbeat economic figures. This week brings the long-awaited preliminary UK GDP figure for the third quarter; a showing of 0.6% is the consensus expectation, which should give the pound some belated support.

EU Summit hardly set the market on fire

It won’t come as much of a shock to learn that last week’s EU Summit yielded little by way of ground-breaking progress on the eurozone’s various debt issues. Merkel even said herself that this wasn’t a Summit where decisions would be made, rather it would pave the way for decisions to be made in December. Headlines focused around the banking union, which is expected to come into being at some point next year, but there was little to get excited about. Market nerves continue to ease though, as demonstrated by declines in Spanish bond yields, despite the fact that we remain in the dark with respect to the timing of bailout request from PM Rajoy.

There is plenty of eurozone growth data to keep an eye on this week, with investors possibly most concerned with conditions in Germany. A key gauge of the German business climate was surprisingly weak last time around and Wednesday morning should shed further light on this issue.

The euro has made a soft start to Tuesday’s session; Greece has stated that a deal must be reached on a €13.5bn package of cuts by Wednesday night, while Moody’s has downgraded five Spanish banks. This has helped sterling climb half a cent above its 5 ½ month lows of €1.2250. EUR/USD has also fallen to $1.30, which should see plenty of euro-buyers return in the short-term.

Sterling has lost grip of the $1.60 level this morning, a development we have anticipated for a while, though we have had to be patient. It now trades at a six week low of $1.5990 and direction from here all depends on what happens to the EUR/USD pair. Our base line scenario is for further losses for both pairs this week.  

End of week forecast

GBP / EUR	1.2325
GBP / USD	1.5975
EUR / USD	1.2950
GBP / AUD	1.5675
Richard Driver Currency Analyst Caxton FX

Roadmap to the Spanish debt crisis

This week is of huge significance to Spain and it might be interesting to give a brief roadmap of how Spain got into its current predicament. Up until 2008, the Spanish economy had been doing well. For instance, real estate prices rose 200% from 1996 to 2007 and the Spanish banking system (with small local banks known as ‘cajas’) had been viewed as one of the best equipped to deal with a financial crisis. Prior to 2008, some regions of Spain were very close to having full employment.

So what went wrong? In the third quarter of 2008, Spain’s economy officially entered recession, after 15 consecutive years of growth. Not a big surprise really, seeing as most countries around the world also went into recession during this period. Rating agency Standard and Poor’s then downgraded Spain’s prized AAA to AA+ in 2009. So, they adopt an economic stimulus plan worth about 5% of their GDP, which leads to the exiting recession in the first quarter of 2010. Things look optimistic.

Then investors start to take a closer look at the Spanish economy and realize that the public deficit is huge: 11.2% of their GDP. After admitting Spain was in trouble, Prime Minister Zapatero introduced austerity measures to address the problem. He raised the retirement age from 65 to 67, reformed pensions and passed a constitutional amendment forcing governments to maintain a balanced budget. Zapatero was then voted out in late 2011, and Mario Rajoy’s conservative party filled the void with an absolute majority.

However, the Spanish economy was already on a downward slide, having produced no growth in Q3 and suffering a 0.3% contraction in Q4 2011. By March, unemployment had doubled the Eurozone average by climbing to 24.4% (it now soars above 25%). In April, thousands protested across the country against the government cuts, adding political instability into the mix.

In the summer of last year the Spanish banking sector began to crumble. Bankia requested a €19 billion state rescue in May, which pushed Spain itself into requesting €100 billion bailout for the struggling banks. In July, one of Spain’s richest regions, Catalonia, requested aid from the central government and several more followed suit as the gravity of the crisis surfaced. With borrowing costs setting fresh record-highs, it has come to a tipping point which appears to have prompted action from the ECB.  

It goes without saying that the European Central Bank’s meeting in Frankfurt tomorrow could be crucial in the context of the Spanish and wider eurozone debt crisis. ECB President Mario Draghi has assured the market that the bank would buy enough bonds on the open market to put a stop to the “financial fragmentation” that currently exists throughout Europe. Draghi has hinted only this week that the ECB is free to buy government bond maturing in three years or less, without breaking the EU treaties and overstepping its mandate by stepping in to money-printing terrritory. This has already had a dampening effect on Spain’s soaring borrowing costs.

Whether the ECB unveils its plan to intervene in the bond markets on Thursday or not, it will do so fairly soon, that much has become pretty clear. But if a country wants to get their hands on this attractive offer from the ECB, they will first have to agree to a set of conditions. Just how strict these conditions are will determine how quickly Spanish PM Mariano Rajoy agrees to request help from the ECB.  He asserted last week, "When I know exactly what is on offer I will take a decision.” Rajoy will not be able to get the ECB’s help for free but certainly Merkel needs to be careful in not overstepping the mark when making austerity demands of Spain’s already crippled economy. There is bound to be plenty of brinkmanship involved if Spain is to request help.

Whilst the ECB meets tomorrow, Rajoy and Merkel will be also be meeting, where it is anticipated that the two leaders will be negotiating an estimated €300bn Spanish sovereign bailout. September was always ear-marked as an all-action month and it looks as if we could indeed be on the brink of some major developments. Whether or not the market will be convinced remains to be seen.

Harry Drake
Caxton FX