February Currency Update

A month ago the brave prediction here was that sterling would trade at a higher level in the new year than its position at the end of the last one. It did exactly that, rising from €1.16 to €1.2050. Job done.

Ah, if only it were that simple… Yes, the pound climbed four and a half cents in less than a fortnight but it spent the remainder of the month falling all the way back. To start with it was the euro indulging in a rally of its own; latterly it has been sterling beating a retreat of its own.

The euro’s situation took a turn for the better when China announced it would invest some of its massive sovereign wealth in the government bonds of troubled euro zone nations, particularly Portugal. To begin with, the market’s reaction was something of a double-take. Was China serious? Why would it do such a thing when the rest of the investment world was nervous they would not get their money back? Portugal was, at the time, seen as the next – and imminent – candidate for a bailout à la grecque and irlandaise. On due reflection investors came to the conclusion that yes, it was in China’s vested interest to keep Euroland, one its biggest export customers, in good shape. As for the credit risk, China’s political ambitions were far more valuable than the odd billion or two that might be lost to a defaulting borrower.

Another step forward for the euro came when Japan pledged to buy a significant portion of a multinational Euroland government bond that would be used to fund the bailout of Ireland. Japan’s finance minister mentioned a figure of “more than 20%”. With those two gigabuck sovereign wealth funds joining the party the Portuguese government was able to run a successful bond auction, borrowing ten-year money below the 7% level that it had earlier described as intolerable. The European Financial Stability Fund’s auction of €5 billion bonds received bids for nine times that amount and was able to pick up its money at an interest rate of 2.89%.

This Chinese and Japanese intervention helped the Europe in two ways. First and most obvious, it did a lot to restore confidence in the euro zone and the euro. Second, it meant the money flowing from the Far East into Euroland would not be flowing into America. When the penny dropped, investors’ support for the euro returned in a rush. The euro climbed by more than eight US cents in the following three or four weeks. It hauled the pound higher against the dollar but sterling/euro inevitably fell back.

More recently it has been sterling making the headlines, not always for the nicest of reasons. Its most spectacular pratfall was in late January when it lost two cents – not just against the euro but against almost everything – as a result of an extremely disappointing figure for growth in the fourth quarter of 2010. The market had been expecting to see growth of round about 0.5%; not spectacular but still moving in the right direction. What it actually got was a figure showing a contraction of that size. Instead of growing in the fourth quarter the UK economy shrank by -0.5%. The news was a shock to the pound and investors were not consoled by the official explanation that December’s arctic weather was to blame. It didn’t matter to them whose fault it was that the economic train had come off the rails; all they cared about was that it was upside down at the side of the track.

To an extent those worries are offset by a change of tone on the interest rate front. After two years during which the subject hardly ever cropped up, the possibility of a UK interest rate increase is now a hot topic. Inflation is up at 3.7%, well above its 1%-3% target range, and two members of the Monetary Policy Committee (out of nine) voted for a rate increase in January. The negative growth figure will prevent any early move but, assuming the economy rebounds in the first quarter of this year, an increase in summer is not out of the question.

A month ago the forecast was that sterling would trade at a higher level during the following 12 months. It is probably safe to repeat that prediction here, but don’t hold your breath for a re-run of January’s boom (and bust).

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This entry was posted on Friday, January 28th, 2011 at 12:11 pm and is filed under Currency Exchange . You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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