Sterling/Euro Currency Review Q1 2011

Friday 15 April 2011

Sterling experienced significant
losses against the Euro throughout the first quarter of 2011, but there
is still some uncertainty for the Euro. 

A blend of poor
economic data, negative sentiment and ever lowering potential for
interest rate increases in the UK all lead to weakness for Sterling
despite positive sentiment amongst traders coming into the New Year.

Sterling
experienced a high of 1.2038 (interbank) against the Euro and a low of
1.1314 (interbank) in the period of Qtr1/11 as all positive signs
surrounding Sterling were quickly reversed.

Despite the average
GBP/EUR exchange rate increasing from 1.1636 (interbank) in Q4/10 to
1.1716 (interbank) in Q1/11, it is the continuous downward trend from
mid January that will be causing the most concern for Euro buyers.

Movement
throughout the first quarter has been largely dictated by interest
rates expectations in the UK, but with a lack of agreement across the
board this has lead to a very unpredictable period, particularly for
GBP/EUR.

Support for Euro

The improvement of Sterling’s
fortunes against the Euro immediately after Point A on the graph saw
Sterling hit a 4 month high of 1.2038 (interbank). It came as a result
of a combination of concerns surrounding the European debt crisis, and
growing confidence that due to ever increasing inflationary pressures in
the UK, the Bank of England would be forced to raise interest rates
well in advance of the European Central Bank, expectations which added
further strength to Sterling.

Many senior members of European
countries made desperate attempts to support the Euro in this period,
including a statement from the French Prime Minister that the “European
debt crisis is not a crisis of the Euro, which remains a strong
currency”.

Nevertheless, the writing seemed on the wall regarding
Portugal’s battle with its debt obligations, as speculators predicted
Portugal was no longer able to finance its financial obligations and the
Euro weakened accordingly.

However, in an unexpected move, on
11th January, both China and Japan committed to and started buying bonds
issued by the Euro-zone. They did so in an attempt to provide support
to the beleaguered Euro. This proved immediately successful and saw
significant recovery of the Euro in the following 2 weeks.

Despite
Sterling’s positive movement in early January, Sterling gains were made
amidst a backdrop of increasingly gloomy economic data in the UK, which
saw declining construction, poor retail sales figures, and a massive
1.3% drop in house prices in December.

These negative figures
accumulated with the announcement of a shock contraction in GDP, which
at -0.5% for Q4/10 left the UK technically facing the potential of a
double dip recession. As a result, towards the end of January GBP/EUR
rates were lower than at the start of the month despite the European
debt crisis.

Reversal of Fortunes

Immediately after Point B
on the graph, Sterling weakness was significantly reversed as strong
manufacturing data (which is widely seen as the cornerstone of any UK
economic recovery), improved business sentiment and an upswing in the
construction sector reduced fears of a double dip recession adding
weight to the argument that poor weather in December was the key
contributor to the negative GDP figure seen on January 25th.

This
lead investors to once more speculate that the UK would lead the
European Central Bank by increasing interest rates in the following few
months, with the NIESR (National Institute of Economic and Social
Research) speculating that the Bank of England would have to raise
interest rates at least 3 times in 2011.

Speculations which
appeared supported by comments from Bank of England Monetary Policy
Committee members Andrew Sentance, Charles Bean and Martin Weale all
suggesting interest rate hikes were necessary, with Andrew Sentance
going as far as to say “Monetary policy would most likely need to be
tightened (interest rate increased) faster and by more than the markets
currently expect”.

This added greatly to Sterling strength as the
higher the interest rate of a country the more investment flows into
that currency.

In the period between Points B and C positivity
surrounding Sterling would have lead to greatly higher GBP/EUR rates
were it not for the extraordinary support and confidence from China for
the debt-ridden Euro, and the ever improving economic figures from
Germany, including a drop in the number of people claiming unemployment
benefit to 7.4%, the lowest level since November 1992.

Showing
that regardless of the economic and financial turmoil felt by many of
the peripheral European countries (where unemployment for the Euro-zone
as a whole still breached the 10% level), the powerhouse of the European
economy was taking significant steps in its economic recovery, adding
great support to the struggling Euro.

And Down Again

However,
sentiment soon changed, and the GBP/EUR rate dropped once more, as
illustrated from Point C onwards on the graph, as Bank of England
Governor Mervyn King took an extremely dovish (negative) stance on
potential interest rate hikes.

Mervyn King contradicted market
views of imminent interest rate increases by saying “Some people are
running ahead of themselves” after the market had priced in an 80%
chance of interest rate increases for May 2011. Mervyn King stated that
he had predicted (on several occasions) that inflation may well top 5%
before steadily correcting lower without the aid of higher interest
rates, leading to another period of Sterling weakness.

In complete
contrast to the Bank of England, members of the European Central Bank
adopted a more positive outlook on potential interest rate increases
signaling the imminent increase of interest rates in an effort to deal
with rising inflation. European Central Bank governor Jean Claude
Trichet noted on the 4th of March that an interest rate increase at the
start of April was a strong possibility, adding significantly to Euro
strength, as did comments from ECB member Orphanides that “Central Banks
should be pre-emptive on inflation”.

Outlook

Going
forward, numerous factors will dictate the direction of GBP/EUR exchange
rate, with the economic outlook for the UK still failing to establish a
significant recovery, as austerity measures take their toll.

The
UK economic recovery still seems significantly behind the curve compared
to the Euro-zone, despite the financial crisis, which will undoubtedly
see Portugal accept an EU financial bailout expected to be in the region
of approximately €80 billion.

Austerity measures are really
starting to bite in the UK. Despite three out of the last four months
showing increases in house prices, rising unemployment, and
announcements on the 31st March that Consumer Confidence has hit 20 year
lows, combined with increases in mortgage defaults, undoubtedly point
to a worrying period of economic and consequential Sterling weakness.

Furthermore,
and as illustrated by Point D on the graph, George Osborne's budget for
the UK announced on 23rd March failed to provide any support for
Sterling, and the downgrade of UK growth forecast announced in the
budget from 2.1% to 1.7% shows how depressed the UK economy remains.

Decreased
growth forecasts lead to credit rating agency Moody’s announcing that
the UK’s much revered AAA credit rating is now under threat. If the UK’s
credit rating is cut it becomes more expensive to borrow money to run
the country and will put Sterling under sustained pressure.

While
the Bank of England Monetary Policy Committee still fails to agree on
how best to deal with inflationary pressures, the European Central Bank
moved on April 6th to increase interest rates for the first time since
July 2008 to 1.25%, adding further strength to the Euro.

However,
Portugal’s almost certain acceptance of financial aid from the EU raises
the potential of contagion of the debt crisis spilling over into Spain.
With unemployment levels over 20%, and an economy four times larger
than that of Portugal, it would prove a massive threat to Euro stability
if Spain were unable to finance its own debt burden.

This could
have extremely negative impact on the Euro, and with estimates that a
financial package if required to bail out Spain would cost €300+
million, it would lead to significant concerns that a bailout package
for Spain would be too costly. In these circumstances the Euro’s
survival as a single currency would be called into question, as Germany
has already appeared reluctant to provide similar financial support to
bail out European countries going forward, as it had previously done for
Ireland and Greece.

Therefore, for all of the obvious concerns
currently surrounding Sterling, the ongoing debt concerns of many
European countries (particularly Spain) combined with the weakness of
peripheral European countries which are likely to be exasperated further
by interest rate hikes by the ECB at the start of April with several
more expected throughout 2011, there is still great potential for Euro
weakness during 2011.