Sterling continued trading in a positive, yet tight, range against the euro throughout Q2 2012, writes Ben Scott.

Sterling started the second quarter of the year positively against the euro and maintained levels above the psychologically important 1.20 (interbank) level, despite the UK officially slipping back into recession.

In the meantime, the euro continued to suffer from its persistent debt problems, political uncertainty and on-going threat of debt contagion.

Sterling touched a three-and-a-half year high of 1.2536 in May after a low of 1.20 at the start of Q2, averaging a rate of 1.2317.

The continual rise in the GBP/EUR rate, after point A (graph), came despite deteriorating economic conditions in the UK, leading to the British Chambers of Commerce to claim that the UK economy is “still facing huge challenges and the recovery is much too slow”.

Figures released 25 April showed a second consecutive quarter of contraction in UK GDP, officially putting UK back in recession, representing the first double-dip recession since the 1970’s.

Sterling, however, was able to make gains against the euro despite far better than expected economic data from Germany, which allowed the eurozone as a whole to dodge slipping back into recession, and in spite of individual countries such as Spain, once more, slipping into recession.

During this period Sterling received safe haven appeal, despite being back in recession. This was supported by credit rating agency Standard and Poor's who reaffirmed the UK's AAA credit rating, including the austerity measures and spending reductions which had led to a form of fiscal stability in the UK as the euro deteriorated.

Greece continued towards financial abyss throughout Q2, with many predicting the removal of Greece from the single currency. Comments from Germany's prominent economic institute, the IFO, such as, "Greece's ability to recover competitive economic standing will be severely constrained if it continues to use the euro", underlining the dire situation Greece faced as debt contagion raged through Europe.

All the while concerns of an imminent debt crisis engulfing Spain saw an almost relentless rise in Spanish bond yields between points A and B on the graph and was a key to euro weakness.

Costs to insure Spanish debt neared the critical 7% level throughout Q2, a level at which Greece, Ireland and Italy had previously had to accept a bailout from the eurozone and International Monetary Fund (IMF) to prevent default on their debt obligations.

Throughout April and into May, the growing Spanish debt crisis, with an economy significantly larger than previously rescued counties, lead to experts questioning the size of funds set aside to fight debt contagion and that it might not be enough to support a Spanish bailout. Hence the phrase, ‘too big to bail, and too big to fail'.

On-going debt concerns left the euro in a state of uncertainty and allowed Sterling to reach multi-year highs against it, with the GBP/EUR rate trading at levels 9% higher than a year earlier. This was compounded by credit rating agency Standard & Poor's downgrade of 11 of Spain's biggest banks (including Santander).

The euro was also handicapped, immediately after Point A, by increased levels of political uncertainty, which saw the collapse of the Dutch government (April 23rd), the failure of Greece to establish a coalition government, but most importantly the French elections on that saw socialist leader Francois Hollande oust President Sarkozy.

French Presidential Elections

Francois Hollande's election was euro negative as Hollande was openly critical of the austerity path chosen for dealing with the debt crisis. He based his election on opposition of austerity measures, which had been closely agreed upon by President Sarkozy and German Chancellor Angela Merkel (the main powers dealing with European debt), indicating he would follow the riskier alternative of borrowing more money which would be used to create jobs and stimulate economic growth.

This also left Chancellor Merkel trying to forge relations with a president who she had already opposed, further leaving the euro in a precarious position.

A period of Sterling weakness (from point B), came after comments from Bank of England Governor, Sir Mervyn King, hinted at further quantitative easing (QE) in addition to the £325 billion already injected into the British economy. QE leads to a devaluation of the currency as more cash is injected into the system. As a result Sterling lost some of its gains against the euro at this point.

King commented that he was "bracing the UK for a storm" as a Greek default moved ever closer, threatening serious knock-on effects to an economy already back in recession.

These comments, although emphasising euro weakness, were the first from a senior UK official suggesting a Greek euro exit could have serious repercussions on the UK’s economy.

Comments from Prime Minister David Cameron and Chancellor George Osborne hinted further at the benefit of additional QE, sending Sterling lower still.

Euro weakness was re-established (from point C) as rumours grew that preparations were being made for a Greek exit, increasing the risks of contagion to peripheral countries such as Spain and Italy.

Simultaneously the idea of Eurobonds, which had been cited as the best way of neutralising the threat of debt contagion by French president, Francois Hollande, Italian Prime Minister, Mario Monti, and Prime Minister David Cameron, were rejected out of hand by Chancellor Merkel, who stated, “under no circumstances” would she agree to German backed Eurobonds, as she was unwilling to burden the German taxpayers with the debt obligations of less austere euro countries, casting further doubts on the future of the euro in its current form.

Sterling gains in this period were restricted by the on-going threat of further quantitative easing, with the IMF proposing that more QE and perhaps even a rate cut from record low levels of 0.5% were needed to boost the economy, but either option would have negative effects on Sterling and the mere mention again weakened the pound.

Minutes from the Bank of England’s meeting in June showed a 5-4 vote to leave QE at current levels. However, such a close vote raised expectations for further monetary stimulus sooner rather than later, putting pressure on Sterling.

Short-term euro stability was re-established towards the end of June on announcements that, finally, ‘Greece has a government’ following negotiations after the vote (17 June) resulting in the formation of a pro-austerity government. Investors saw this as a positive in what had been billed as a 'Yes' or 'No' vote on the euro.

Stability on the back of the Greek election will prove fragile as each of the three political parties which united to form the coalition government have different priorities regarding a re-negotiated austerity deal.

The end of June saw Spain officially requesting financial aid of up to £100 billion for its stricken banking sector, whilst Cyprus was forced to request financial aid from the IMF meaning the vital European summit, due to complete at the end of June, has taken on even more significance with regards to the euro’s future. Dallara of the Institute of International Finance stated, “The EU summit is perhaps the most important since its founding; EU’s future is at stake”.

Outlook

Going forward, the direction of GBP/EUR will be dictated by the debt crisis gripping Europe, with the IMF stating, “The crisis in Europe has reached a critical stage and threatens to tear the single currency apart”.

Despite the formation of a pro austerity government in Greece in the last weeks of June, markets anticipate that Greece leaving the euro has not been diverted - rather delayed; Citibank still sighting a 50/50 "at best" chance of Greece remaining in the euro and following austerity agreements.

Comments from Standard and Poor’s highlight the risk to the eurozone, saying, “If Greece were to leave it would threaten the entire eurozone’s credibility”, meaning all European countries could be subject to further credit downgrades, which would prove disastrous for the euro.

The establishment by the G20 of the 'Save Europe Fund', should eventually provide some stability, however, figures suggest only US$30 billion of the pledged US$430 billion is readily available, meaning stability might not come fast enough.

Italy's Prime Minister stated on 19 June that "euro heads (are) to make crisis decision in next 10 days", suggesting weakness for euro is a very real possibility, with the cost of borrowing money remaining at unaffordable levels in Spain and with Angela Merkel stating, “not in my lifetime”, when discussing the potential of Eurobonds to stabilise the European economy, the outlook for the euro remains bleak.

Sterling continues to look vulnerable too, despite economic figures in the UK showing some signs of improvement towards the end of June, including an unexpected drop in unemployment, stronger than expected retail sales figures and improved manufacturing figures have helped Sterling's appeal though.

The joint announcement at the end of June by BoE governor, Mervyn King, and Chancellor, George Osborne, to increase liquidity should improve economic conditions. However comments from King, apparently laying the foundations for further rate cuts, will weigh on Sterling going forward.

All rates are quoted as interbank rates.

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