by Adam Solomon
Sterling / Euro and US Dollar
The Pound made unlikely gains against the Euro exchange rate yesterday, 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 1.1250 versus the Euro by the close of trading last night, after the ECB Chairman Jean-Claude Trichet delivered a dovish stance on economic growth and failed to indicate that further rate increases are likely.
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 rate in June.
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 yesterday showed that services sector growth slowed by more than forecast in April and the data follows further declines in construction, manufacturing and housing this week. Euro buyers would be well placed to take advantage of the mini-revival this afternoon because a move under 1.10 still appears increasingly likely.
The Bank of England interest rate announcement largely took a back seat yesterday 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 next 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 yesterday 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 yesterday’s 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.
In terms of economic data, the Pound bounced back from earlier reports that UK services declined by more than expected in April. The key components of the economy appear to be slowing once more and there will be speculation that UK GDP could fall into negative territory in the second quarter following the anaemic 0.5% expansion in the first three months of the year.
The Pound has declined heavily against the U.S Dollar this week and fell under 1.64 in the build-up to this morning’s producer price data. The Office of National Statistics is expected to report that UK factory-gate inflation rose just 0.7% in March, despite interest rates remaining at the lowest level on record.
Euro / US Dollar
The Euro exchange rate declined by the most against the U.S Dollar in eight months yesterday, 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.
Although Trichet said that inflation risks were still to the upside, making another rate increase is just a matter of time, the Euro declined heavily across the board amid disappointment that rates would not be increased next month. The latest U.S economic data was again sharply lower than initial forecasts with an increase in U.S jobless claims to the highest level in eight months.
The data triggered a sharp deterioration in risk appetite, which ironically benefited the Dollar from a safe haven perspective, and there was also a downward move in commodity prices as oil fell by over $12 a barrel to below $100. The combination of short Dollar covering positions and a corrective decline in the Euro pushed the single currency towards 1.45 by the close of trading last night.
U.K 09:30 – Producer Price Index (April) – Output
GER 11:00 – Industrial Production (March)
U.S 13:30 – Non-Farm Payroll (April) – Average Earnings – Unemployment
U.S 20:00 – Consumer Credit (March)