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Money & Finance

Sterling/Euro Currency Review June 2014

Wednesday 02 July 2014

June saw Sterling make significant gains against the euro, as the outlook for interest rates for the Bank of England and European Central Bank continue to diverge, much to the benefit of euro buyers, says Ben Scott.

Economic data from the UK continued to reflect economic improvements, which lead BOE Governor, Mark Carney, to admit that “(With) improvement of the economy and a surge in house prices it is coming to the point where interest rates would need to rise”.

This was in direct contrast to the ECB, which cut interest rates in June, to the detriment of the euro, before ECB Executive Board Member Benoit Coeure stated that the ECB would “keep rates close to zero for an extremely long period”.

After an initial low of 1.2269 (Interbank throughout), GBP/EUR reached an 18-month high of 1.2563 (point B on the graph), trading at an average rate of 1.2427 throughout June.

Despite manufacturing, industrial production and service sector figures all signalling continuation of the ongoing economic recovery in the UK, the BOE remained intent on downplaying Sterling strength early in June, resulting in the month low as illustrated by point A.


GBP/EUR strength thereafter was a direct result of the ECB making good on President Mario Draghi’s warning in May when he stated that the ECB was “comfortable with acting next time”.

In an effort to counter the threat of deflation the European Central Bank cut its bench interest rate from 0.25% to a record low of 0.15%, whilst simultaneously cutting the deposit rate for banks from zero to -0.1%, becoming the first major Central Bank to charge fees on bank deposits.

Although the intention of the policy is to stimulate bank lending to the real economy, the euro may weaken further as banks move excess reserves into higher yielding currencies, therefore leading to extended euro weakness, which sent GBP/EUR to 18-months highs.

Euro weakness was intensified by comments from ECB President, Mario Draghi, that “they were not finished yet and that if inflation remains low they will act again with further unconventional measures”, to the further detriment of the euro.

Figures from the Office for National Statistics, showing further declines in the rate of unemployment in the UK (lowest level in over five years at 6.6%), supported Sterling’s gains, before the Bank of England Governor, Mark Carney, surprised the markets by stating “interest rates could rise sooner than expected”.

This proved the catalyst for a break of 18-month highs (point B) as markets took this as an indication that interest rates could rise before Christmas 2014, making Sterling a far more attractive investment than the euro.

Sterling gains were nevertheless broken leading to point C as a result of the mixed signals from the BOE regarding interest rate expectations.

Despite hawkish comments from Governor Mark Carney earlier in the month, he seemed to back track when he told the Treasury Select Committee that, “there is additional spare capacity in the UK labour market that can be absorbed before any increase in the base rate”.

BOE Policymaker, Martin Weale, went further to play down the prospect of a 2014 rate hike when he commented that, he did not see a need to raise interest rates immediately. He further stated that, “we should wait for further evidence of economic recovery”. As a result, this lack of clarity from the Bank of England caused further uncertainty.

Outlook

Numerous factors will determine the short-to-medium term direction of GBP/EUR rates. Whilst the UK’s economic outlook continues to improve, respected bank Societe Generale suggests, “Plenty of good news is already priced in”.

Given the uncertainty surrounding the interest rate outlook caused by recent conflicting comments from Governor Carney and the Bank of England, it seems likely that the anticipation that the BOE could and should be the first major central Bank to hike rates could largely be reflected in current prices.

This would mean that without positive data from the UK, Sterling’s fortunes could quickly reverse, particularly after measures aimed at curtailing the housing boom takes full effect.

Despite slight improvements in overall economic data from the eurozone, including an increase in retail sales, and improved consumer confidence and business data in Germany, economic data from Europe’s second largest economy, France, continues to disappoint, weighing on both the economic recovery in the eurozone and the euro.

As seen in early June the euro experienced significant weakness when the ECB cut rates. Given the negative comments from ECB member, Jozef Makuch, that “there is still room to cut [the] benchmark rate”, and ECB’s Erkki Liikanen, that “we are not done yet”, there are undoubtedly indications that the ECB may be set to introduce further monetary easing, which would almost certainly result in further euro weakness.

Ben Scott
Foreign Exchange Ltd
www.fcexchange.co.uk

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