by Adam Solomon
Sterling / Euro and US Dollar
Following on from last week, the Pound failed to receive a boost against the majors, after the Bank of England decided to keep interest rates unchanged at a record low of 0.5%. The UK currency slumped to 1.6250 versus the Dollar and 1.13 against the Euro after the ECB press conference on Thursday. The central bank also kept interest rates on hold this month but in the accompanying statement, the chairman Jean-Claude Trichet, gave a strong indication to the market that the governing council will be raising the benchmark lending rate in July.
His hawkish rhetoric on inflation was followed by the key term that “strong vigilance” is required in order to maintain risks to price stability. Trichet has historically been very transparent on the ECB’s monetary outlook and the Euro has been gaining for the couple of weeks on speculation that the central bank would increase interest rates to 1.25% in July.
Therefore, the Euro hasn’t rallied to a degree that one might expect following the statement, largely because a rate increase has been factored into the market and that is the primary reason the Euro has gained versus the Pound for six days consecutively. However, given the inherent weakness in Sterling and the negative sentiment engulfing the UK economic outlook, the Euro still staged a move towards 1.10 to test the support level from the previous downside move.
The single currency also had a subdued response against the Dollar following the statement, trading back towards 1.4350. The downward movement on EUR/USD also saw the U.S Currency strengthen versus the Pound, indicating that the Euro’s incredible rally over the past two weeks was over-exaggerated and we’re witnessing a correction in the market.
The Bank of England left interest rates unchanged at 0.5% and investors will have to wait until the minutes of the meeting are released later this month to gauge how the MPC voted in June. Recent economic data has pointed to a loss of momentum in the recovery and policy makers are focused on supporting growth rather than tackling inflation.
The BoE also left its bond purchase program on hold at £200 billion and Mervyn King’s push to maintain low interest rates won the support of the IMF last week, which said it’s appropriate to maintain the “current scale of monetary stimulus.” While inflation is more than double the government’s 2% target, support for higher interest rates has been eroded by Andrew Sentance’s departure in May, exactly a year after he first called for higher rates.
The UK economy stagnated in the six months through March, barely erasing the contraction in growth from the fourth quarter of 2010. Consumer spending slumped by the most in almost two years in the first quarter and surveys last week pointed to further weakness, as manufacturing expanded at the slowest pace in 20 months in May and services growth cooled.
According to the sterling overnight interbank average, investors are now betting on a 25 basis point increase in UK interest rates in April next year and that forecast is being scaled back almost on a weekly basis, undermining confidence in the Pound. The IMF has lowered its 2011 UK growth forecasts this week to 1.5% and Moody’s Investors Service has warned that the UK could be subject to a credit rating downgrade if the government fails to meet its deficit reduction target this year.
The Pound also came under pressure on Friday amid further uncertainty surrounding the UK growth forecast and the overall tone was pessimistic. In terms of economic data, the UK trade data was marginally better-than-expected with the deficit for April £7.4 billion and there was still some expectation that the economy can secure strong growth through rising exports.
The Pound declined against the Euro on Friday and gilts reached the lowest level this year, after a report in the UK showed that manufacturing fell by more-than-expected in April. The UK currency also traded at the lowest level against the Dollar this month, as factory output slumped 1.5% from the previous month, the biggest drop since January 2009.
A separate government report showed that producer prices rose just 0.2% in May, indicating that a measure of inflation from the increase in factory prices is slowing. The result was actually the least since September and indicates that growth and inflation are slowing. The Pound was trading lower against 15 out of the 16 most actively trading currencies, dropping for the third straight day against the Dollar.
In terms of economic data, the focus this week will fall on the latest inflation figures for May. Consumer prices are expected to show that the annual rate of inflation remains well above the government’s 2% target and officials anticipate the headline rate to breach 5% over the coming months. However, this is unlikely to alter the view that the BoE will keep rates on hold for the remainder of the year and focus on supporting growth.
Elsewhere, the underlying weakness in the UK economy is likely to be evident this week with UK unemployment and retail sales numbers due for release. The jobless rate is expected to remain at
7.7%, helping keep wage growth subdued. The retail sales report should reflect the recent drop in consumer spending, as the government’s fiscal cuts dampen sentiment.
Euro / US Dollar
The Euro spiked higher against the Dollar at the start of the ECB press conference on Thursday, before retreating sharply following mixed comments from the chairman Trichet. The single currency recorded the first weekly drop against the Dollar in a month, as investors speculate on how aggressively policy makers will raise interest rates this year.
The Euro exchange rate also declined against the Dollar, amid reports that China was converting large volumes of Dollars into Euros, while speculation intensifies that the ECB will slow the pace of interest rate increases this year. The single currency was unable to break 1.4550 on Friday and was subjected to renewed selling pressure later in the day.
The structural vulnerabilities within the Euro-zone will also continue to undermine the Euro, as political debate over the Greek debt situation persisted. The German government and Euro-group head Juncker reiterated that there would need to be some form of voluntary debt restructuring for Greece as part of any fresh support package.
The lack of a resolution surrounding the Greek debt situation continued to undermine confidence in the Euro and there were fresh concerns that European banks were withdrawing funds from weaker economies. However, given the lack of confidence in U.S economic data, it will be difficult for the Dollar to make much headway, even with demand from a safe haven perspective.