May proved to be a mixed month for sterling which experienced a negative start against the euro before rallying on the back of David Cameron and the Conservative Party achieving a majority government, says Ben Scott.

A resounding Conservative success was achieved despite all polls leading up to the election suggesting it would be an extremely close run election with almost all indicators forecasting the UK and therefor the pound would be subject to a hung parliament and the uncertainty of another coalition government.

With the euro remaining extremely price-sensitive to headlines regarding Greece, sterling was once more able to benefit pushing back towards eight-year highs against the euro.

A GBP/EUR low of 1.3362 (Interbank throughout) as illustrated by point B on the graph, was followed by a period of sterling gains, including a high of 1.4172 on 27 May 2015 (point C), trading at an average rate of 1.3815 throughout May.

Sterling weakness from point A on the graph came partly as a result of disappointing economic data, which was reflected by a decrease in consumer confidence, UK factory growth, construction figures and poor retail sales figures. However, the main reason for sterling weakness during early May was undoubtedly the uncertainty regarding the UK general election. Market concern grew that a potential Labour-led coalition would prove extremely negative for the UK economically. A sentiment supported by respected investment bank, Morgan Stanley, who before the election forecast “even further uncertainty and sterling weakness” would be possible.

Fortunately for the pound such concerns proved unfounded and the relief created by the stability of a ‘business-friendly’ Conservative majority was instant. This was illustrated by the sharp sterling correction higher (point B) the morning after the general election, with sterling almost instantly recovering 3% against the euro.

Whilst the stability of a majority government allowed sterling to push back towards the seven-year highs seen in March, Greek debt woes were the key contributor to euro weakness during this period. Although Greece successfully made a debt repayment of €750million to the International Monetary Fund (IMF), the announcement that funds had originated from an emergency account simply compounded concerns that Greece is quickly running out of cash and stands on the brink of default.

Concerns grow that Greece will not be able to make its next significant debt repayment of €1.5billion to the IMF on 5 June , Greek lawmaker and parliamentary speaker, Nikos Filis, highlighting the importance of the situation proclaiming; “Now is the moment of truth, on June 5th. If there is no deal by then that will address the current funding problem, they won’t get any money”. Such comments, whilst emphasising the dire situation Greece is faced with, raises questions as to whether hardline negotiations are a sensible approach, with Germany in particular, unlikely to respond well to such comments.

Despite positive comments from Pierre Moscovici (European Commissioner for Economic and Financial affairs), who claimed that “there has been important progress on Greece”, there is undoubtedly a growing urgency for a resolution. Given this current urgency, it is surprising that sterling gains in this period were not significantly larger, however, this can be largely attributed to the announcement on 19 May that UK inflation had turned negative in April 2015 at -0.1% and for the first time on record (55 years) after the CPI (Consumer Price Index) was announced.

Whilst negative inflation had been widely forecast by the Bank of England (BOE) earlier in the year and is expected to be only a short-term concern, it does reduce the potential of a UK interest rate increase. Many now forecast the first BOE interest rate hike will not come until 2016, making sterling far less attractive to investors.

Numerous factors will determine the short-term direction of GBP/EUR rates. UK economic growth continues, although at a far slower rate than anticipated with sterling sliding towards the end of May on the announcement that economic growth in the first quarter of 2015 was below a forecast level of 0.4%, coming in at 0.3%, raising concerns that economic growth will stagnate throughout the rest of the year.

A potential negative for sterling going forward is the commitment from the Conservative Government to allow a referendum on the continuation of the UK’s EU membership. A referendum will almost certainly lead to significant uncertainty raising the very real prospect of sterling weakness as uncertainty grips the markets. This uncertainty was demonstrated by last year’s Scottish independence referendum which lead to heavy swings in the value of sterling. As Bank of England Governor, Mark Carney, stated, “If the UK is going to hold a referendum on our membership with Europe it needs to be done soon to remove the uncertainty that it brings”.

Whilst the euro has been boosted in recent weeks by the apparent success of the European Central Banks (ECB) quantitative easing (QE) programme, which according to reports is running to plan, and looks set to return inflation to target levels within the next two years, the ongoing Greek debt debacle looks set to continue to directly impact the direction of the euro.

Although there is a growing belief that Greece will in fact successfully make their next debt repayment on June 5th, many market commentators still feel a default is inevitable. A significant barrier to progress on the Greek debt crisis appears to be the strained relationship between German Finance Minister, Wolfgang Schauble, and Greek Finance Minister, Yanis Varoufakis.

Schauble contributed to euro weakness in May by going back on a previous assurance on the prospect of a Greek default admitting that he “doesn’t rule out a Greek bankruptcy”.

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