July saw Sterling add to gains made against the euro throughout June, pushing towards two-year highs, says Ben Scott.

The pound was again buoyed by largely positive economic data and growing forecasts that the Bank of England (BOE) could hike interest rates this year.

This remains the growing divergence in policy between the Bank of England and European Central Bank (ECB), which continues to weigh on the single currency, particularly speculation that the ECB is set to introduce some form of quantitative easing (QE).

Euro buyers will be buoyed by the ongoing theme from the ECB that there will be low interest rates for the foreseeable future, with ECB President, Mario Draghi, admitting that he sees “ECB rates at current levels for extended period”.

Such forecasts weighed heavily on the euro and contributed to Sterling’s rally to 23-month highs of €1.2699 on 23 July 2014 (interbank throughout) as illustrated by point C on the graph.

After touching an initial low of €1.2486, GBP/EUR traded at an average rate of €1.2605 throughout July 2014.

Further Sterling gains were prevented during July as a result of comments from the British Chamber of Commerce. They warned against a rate hike, and further suggested that the economic recovery is decelerating, cautioning that “recent figures have showed signs of a slowdown in growth in some sectors of the economy and a sustained period of low interest rates would provide firms with security and future stability”, alluding that an interest rate increase this year would be detrimental to the UK’s economic recovery.

Euro weakness to point B was caused, in part, by poor economic data from Germany and France, providing further evidence that German economic recovery is no longer in a position to support the underperforming economies of peripheral European countries.

However, Sterling also gained during this period on higher than expected inflation data, which provided additional support for calls for the BoE to increase rates.

Outlook

Data released in July indicated that the UK’s economy grew 0.8% in Q2.2014, meaning the UK’s economy is now 0.2% ahead of the pre-crisis peak seen in 2008, leading the IMF to increase the UK’s economic growth forecast for the fourth consecutive time.

Nevertheless deteriorating economic data from the UK manufacturing and service sectors adds to concerns that the UK’s economy is now actually starting to stagnate, reducing the potential of an interest rate increase this year.

With indications suggesting that a rate hike may already be partly priced in to the pound, a delay in any rate increase until next year could result in recent Sterling gains quickly being reversed.

A significant concern for Sterling going forward is the fact that both the IMF and BoE policymaker, Dr Ben Broadbent, have recently indicated that the pound could be overvalued as much as 10%.

The IMF stated that an overvalued pound would “provide a barrier as the UK economy seeks to rebalance, which is vital for a sustainable economic recovery”. This adds to concerns that Sterling strength may have a negative impact on exports, which could lead to a concerted effort to devalue the pound.

With the ECB looking primed to introduce quantitative easing, and with the potential of an economic recovery looking unlikely, the euro looks set to remain under pressure.

However, in the short-term the most pressing concern for the euro are concerns surrounding Portugal’s banking sector. July saw Portugal’s second largest bank Banco Espirito report a bigger than expected loss of €3.6billion for the first six months of the year.

This sent shockwaves around the world with immediate concerns that a bank failure could lead to a fresh eurozone crisis, which would prove catastrophic for the single currency.

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