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
