by Adam Solomon
Sterling / Euro and US Dollar
Following on from last week, The Pound made unlikely gains against the Euro on Thursday, despite the drop in UK services sector growth, which preceded the Bank of England’s decision to hold interest rates at a record low 0.5%. Sterling rose towards 1.1350 against the Euro, after the ECB Chairman Jean-Claude Trichet disappointed investors and delivered a dovish stance on economic growth and gave no indication whether the central bank would raise interest rates again.
Trichet also warned that the economic outlook is uncertain and he refrained from the reference that strong vigilance is required to maintain risks to price stability in his opening statement. The Euro immediately came under renewed selling pressure, falling back towards 1.4720 against the U.S Dollar. Investors were hoping that Trichet would use the press conference to deliver a hawkish rhetoric on inflation and signal a further increase in rates next month.
The dovish tone of the statement was a surprise to investors and the Euro lost ground against the majority of the 16 most actively traded currencies. For the Pound, this will probably be a short reprieve, as the ECB are still likely to increase borrowing costs again before the Bank of England. A report in the UK on Thursday showed that services sector growth slowed by more than forecast in April and the data follows further declines in construction, manufacturing and housing last month.
The Bank of England interest rate announcement largely took a back seat and the reaction in the market was muted following the decision to keep rates on hold at 0.5%. Policy makers are concerned that the economic recovery is losing some momentum in the second quarter, after a string of negative economic reports.
BoE officials will publish new growth and inflation forecasts this week with the panel split on the timing of a potential increase in borrowing costs. It represents a difficult balancing act for the MPC who are concerned the fragile nature of the economic recovery will be impacted by the government’s austerity measures, while inflation continues to accelerate to more than double the 2% target.
Investors have been scaling back interest rate expectations over the past couple of months, amid suggestions that policy makers will keep rates on hold until November. The National Institute for Economic and Social Research lowered its 2011 growth forecast for the UK economy to 1.4% from 1.5% in January, and raised its inflation estimate to 4.5%.
Slowing growth and faster inflation will increase concerns over stagflation in the UK and the Bank of England dare not switch to a tightening bias until the economy shows signs of sustained growth. Investors will have to wait until the minutes of the meeting are released on May 18th to see how the committee voted this month. Andrew Sentence, who has voted for a rate increase since the middle of last year will be leaving the MPC on May 31st, reducing the chance of a majority vote next month.
The Pound declined heavily against the U.S Dollar last week and fell under 1.64 in the build-up to the producer price data on Friday. The Pound continued to rally against the Euro but the UK currency came under further selling pressure, after UK producer prices rose at a slower pace in April, which indicates that inflationary pressures are subsiding, increasing bets that the Bank of England will leave interest rates unchanged.
UK stocks dropped for a second day and global risk appetite waned, which helped underpin a resurgence in support for the U.S Dollar. The Pound traded under 1.64 for the first time this month, as investors sought the security of lower-yielding assets. The Pound also came under selling pressures, after the Confederation of British Industry reported that the economy will grow at a slower pace than previously expected this year and in 2011.
The UK currency fell to a low of 1.6344 against the Dollar over the weekend and lost ground from a peak of 1.1411 versus the Euro, after the governor of the Bank of England Mervyn King said that high debt levels pose “massive economic challenges that would be exacerbated in increased long-term interest rates.”
In terms of economic data, the focus this week will fall on Wednesday’s Bank of England quarterly inflation forecasts. Given the recent comments from Mervyn King and unexpected decline in consumer price inflation, the report is not expected to provide any underlying support to Sterling. Data of note over the week also includes manufacturing production for March and the BRC retail sales report.
Euro / US Dollar
The Euro declined by the most against the U.S Dollar in eight months last week, as the ECB kept interest rates on hold and Trichet failed to signal any further increases are likely over the coming months. Commodity driven currencies like the Australian Dollar and Norwegian Krone also dropped significantly, as raw materials prices slumped by the most in two years and risk appetite waned.
Although Trichet said that inflation risks were still to the upside, the Euro declined heavily across the board amid disappointment that rates would not be increased next month. The single currency also came under fresh selling pressure, as concerns grew that Greece’s debt crisis is worsening. Germany’s Spiegel magazine said that Greece may withdraw from the Euro altogether.
The Euro encountered resistance just above 1.4750 against the Dollar on Friday, in the build up to the U.S non-farm payrolls data and drifted back towards 1.45 later in the day. The headline figure was higher-than-expected at 244,000 for April following an upwardly revised 221,000 gain the previous month. The unemployment rate rose to 9% from 8.8% the previous month.
Data Released Today
EU 09:30 – Sentix Index (May)