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
