April 2013 Outlook: Sterling edges higher as debt crisis resurfaces

After an awful start to the year, sterling has benefited from a welcome boost on the exchange rates in recent weeks. A couple of positive domestic economic developments have helped matters but events in the eurozone have been the key driver, helping to put the UK’s troubles in perspective. Domestic growth data in March did little to significantly improve the outlook for the UK recovery, though a couple of bright spots have provided a much-needed source of hope. There has also been a lack of further dovish leanings within the Bank of England, though we do expect more QE to be announced in May.

There was a collective sigh of relief that Cyprus avoided an unprecedented euro-exit and more

importantly that the eurozone banking system avoided the shockwaves which would inevitably follow. Nonetheless, events in Cyprus have understandably shaken the euro in the past month. The bailout deal that Cyprus reached with the Troika will leave the country deep in recession for a long time to come but this won’t be the market’s primary concern. Alarm bells are ringing following mixed rhetoric from within the EU leadership over whether the “bail-in” – where private investors and depositors, not taxpayers footed the bill for the refinancing – represents a special case or not. Some dangerous precedents have been set and with other larger eurozone strugglers such as Portugal and Italy exhibiting some tell-tale signs of crisis further down the line, the euro could be set for a troublesome few months.

GBP/EUR

Cyprus has investors fleeing for safety

Sterling looks to have bottomed out against the euro for the time being. The wave of anti-sterling sentiment has abated for now, amid a feeling that most of the bad news is already out in the open with respect to the UK economy. If the last few weeks have taught us anything, it’s surely that all the bad news is certainly not out in the open with respect to the eurozone.                      

                            

The pound emerged from the Annual Budget more or less unscathed, despite Osborne revealing that the Office of Budget Responsibility has slashed its 2013 GDP expectations from 1.2% to just 0.6% (which will most likely be undershot). Osborne effectively passed the buck to the Bank of England in terms of efforts to stimulate UK growth, directly expanding its mandate to that effect.

The latest from the Bank of England is that Mervyn King and his two fellow doves (Fisher and Miles) remain in the minority on the key quantitative easing debate, with the other six members seemingly too concerned with rising UK price pressures. In addition, the March MPC minutes revealed that there were fears surrounding an “unwarranted deprecation in the value of the pound,” which will concern many of those betting against the pound. We feel safe predicting that there will be no dovish majority in favour of QE in this Thursday’s MPC meeting, though we see a probability that we will see the voting swing in favour in May.

UK Q1 GDP figure comes into focus

Growth in the UK clearly remains very weak indeed. February’s data revealed the worst monthly construction growth in three years, whilst manufacturing is also firmly in contraction territory. Gladly, there was some relief in that the dominant UK services sector posted its best figure in five months and February’s 2.1% retail sales growth was excellent.  However, the key issue of whether or not the UK economy will avoid a triple-dip recession, when its Q1 GDP figure is announced on April 25, remains finely balanced. The March PMI figures released over the coming sessions will be highly significant; this morning’s manufacturing update got things off to a weak start but as ever, the pressure will be on Thursday’s services figure to deliver again.

Dangerous precedents will hurt the euro

While, there have been some rare sources of positivity with respect to domestic developments, this pair’s recent climb is explained mostly by events in the eurozone. Cyprus stole the headlines; the dreaded euro-exit has been avoided once again but the market has been left with some rather uncomfortable lessons. In a fundamental shift in eurozone banking relations, private individuals and companies with large amounts of cash in European banks now find themselves at risk of other potential ‘bail-ins’ in other struggling nations. This new credit risk is likely to leave a major psychological mark on euro-depositors and will have many heading to the exits and targeting perceived safer options like the GBP and USD.

Where will the next debt crisis hotspot be? Italy is looking a decent bet. Political instability is not the only issue the country faces, economic contraction remains a major issue and perhaps more pressingly, the health of Italian banks is deteriorating at an alarming rate. If things continue at this rate then Italy could find itself in a similar position to Cyprus, in need of recapitalising its banks, with Germany opposing a fix-all bailout from the European Stability Mechanism.

Some dangerous precedents have been set in Cyprus in terms of depositors being forced into a ‘bail-in,’ senior bondholder suffering haircuts, major and extended capital controls being implemented, the ECB imposing strict deadlines on their liquidity provision. Lines in the sand have been drawn, which are fundamentally likely to undermine confidence in the euro.

Debt crisis to one side, eurozone data has remained disappointingly true to its downtrend.  Monthly growth data from Spain, France, Germany and the eurozone as a whole has all undershot expectations, which suggests that Draghi is being more than a little overoptimistic with respect to his expectations that the region’s recession will stabilise soon. Naturally, events in Cyprus have hurt confidence and sentiment gauges.

Sterling has recently posted seven-week highs of €1.1890, although this pair currently trades over a cent off this level. We do see GBP/EUR recovering further in the weeks ahead, particularly if the BoE delays QE this month and the UK services figure is solid. Asian reserve managers already appear to be responding to eurozone developments by taking a step back from the euro. We see this trend continuing, which could take this rate as high as €1.20 in the weeks ahead.

GBP/USD

Sterling finally enjoys a bounce

There is no doubt that sterling’s safe-haven status has waned in recent months, in line with the loss of the UK’s AA credit rating. It has therefore been no surprise to see the USD benefit from the lion’s share of safe-haven currency flows stemming from increased tensions in the eurozone. Nonetheless, the pound has managed to eke out some gains in the past three weeks or so, despite the uptrend in US economic figures.

Those economic figures have revealed a particularly strong increase in US retail sales and industrial production. However, with housing market data mixed and consumer sentiment gauges indicating some weakness, there remains more than enough cause for concern to see the Fed continuing with QE3 for the time being. Indeed, the Fed recently downgraded its 2013 GDP projections in anticipation of a fiscal drag later this year.

More improvements in US labour market

As ever analysis from inside the Fed and therefore throughout the market, will focus on the US labour market, from which the news has been distinctly positive over the past few weeks. The US unemployment rate dipped back down to 7.7% in February- its lowest level since February 2009, while the headline figure revealed 236,000 jobs were added to the payrolls – the biggest monthly increase in a year. There is plenty here to fuel the Fed hawks’ calls for scaling back QE3 but the bottom line is that Bernanke and his fellow doves still require further progress. They may well get what they want as this Friday’s key US labour market update once again promises to be robust.

There were some notable phrases within the Fed’s March statement, among which was the emphasis that the central bank has the ability to vary the pace of QE3 in response to changes in the US economic outlook. So it really does seem as if they are gearing us up for fazing QE3 out, though this remains conditional to labour market progress.

Sterling may well face some short-term weakness if the UK services figure disappoints and there is room here for a move down to $1.5050. However, our baseline scenario is for a further upward correction for this pair. A move up towards $1.55 is possible in the weeks ahead, though this comes with the caveat that the UK must avoid a triple-tip recession (no sure thing). Beyond this near-term upward correction, we maintain a negative outlook for this pair in H2 2013, in line with our positive outlook for the US dollar.

GBP/EUR: €1.20

GBP/USD: $1.53

EUR/USD: $1.27

Richard Driver
Analyst – Caxton FX

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