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The Best Laid Plans of Mice & Men

Back in the hazy days of summer, when certainty was the watchword of the FX markets and volatility had been consigned to the archives of the financial markets, the path for US & UK interest rates and by extension the path for the US dollar and Sterling seemed mapped out for the year ahead.

Meanwhile in Europe, the Ukraine crisis is a further blow to the moribund European economy while the forward looking PMIs and the ZEW surveys seem to also point to a slowdown in activity.

As Europe slipped ever closer to outright deflation and a triple dip recession became more than a theoretical possibility as the German economy contracted by 0.2% in Q2, the flight path for a weaker Euro seemed preordained.

However we should be always aware that exchange rates represent the relative performance between trading areas. The clarity that the Market foresaw for both US & UK interest rates in the summer has dissipated dramatically, and is being replaced by uncertainty – the flight path for the US dollar and Sterling is no longer clear, this is especially the case for the pound.

German ZEW Expectation of Economic Growth over the past 12 months - Source: Bloomberg

German ZEW Expectation of Economic Growth over the past 12 months – Source: Bloomberg

What has changed?

The Market has had to change its target date for the first rise in UK interest rates from initially, Q4 2014 to Q3 2015. It has done so because of the lack of inflation, as well as pockets of outright deflation in some sectors of the economy. The UK CPI (BOE target 2%) fell from 1.5% in August to 1.2% in September (the lowest in five years) with no noticeable uplift in wages. Average earnings, excluding bonuses, in the May to July period rose by 0.7% from a year earlier.

The outlook for inflation remains subdued and could go lower as oil and other commodity prices continue to soften. Without inflation and a pick up in wage growth, it is difficult to see other members of the MPC joining Ian McCafferty and Martin Weale in calling for an increase in UK interest rates.

Subsequently, if we take away the prospect of higher rates we remove a key support for Sterling. For sure, the UK economy is performing well in comparison to the Euro economy, but is that enough to convince the Market to hold the pound? Ordinarily it most likely would. but politics has muddied the economic waters.

Although the reaction to the result of the Scottish referendum was Sterling positive, it has awakened in investors the dangers and the reality associated with a UK exit from the European Union, it has also highlighted the fragility of the present UK union – uncertainty is anathema to the Markets and will encourage many to forsake the pound.

UK Consumer Prices (CPI), Inflation - Source: Bloomberg

UK Consumer Prices (CPI), Inflation – Source: Bloomberg

The outlook for Sterling

Short term (to year end), Europe and monetary policy actions from the ECB are likely to dominate. The spectre of deflation coupled with a European economy flirting with recession may be forcing the ECB down the road of quantitative easing (QE). The prospect of such action will keep the Euro under pressure and Sterling may enjoy some strength against the single currency. I suspect that any strength will not see a break of the year low and major support at .7750/60.

I expect this level to hold and the Pound will be sold on bouts of uncertainty around QE and any negative UK economic releases. These sell offs will most likely see Sterling test major resistance at .8060/70 against the Euro, through here and we could eventually test up to .8224.

Longer term I expect politics to increasingly impact the pound and provide a stumbling block to deeper Sterling appreciation (sub .7750, towards .7500). Adding politics to the economic mix makes the truism that forecasting exchange rates is a task for a monkey and a dart board all the more accurate. Nevertheless as I formulate my longer term outlook for the Pound, I would love to hear your thoughts on where you see Sterling trading in 2015.

4 Responses to The Best Laid Plans of Mice & Men

  1. DT October 22, 2014 at 7:40 am #

    Nice piece – I pretty much agree.

    The bottom line, in my opinion, is that the FED and BOE have come out almost together to say that it may be longer than originally forecast before raising interest rates. This immediately weakened the dollar and the pound which is exactly what they wanted for obvious reasons.

    In my opinion, this was nothing more than a stunt to weaken their respective currencies in the short term. Yes, their are issues and concerns but the fundamentals haven’t changed significantly in either the U.S. or the U.K and both economies have made huge progress compared to the Eurozone.

    I understand that the Eurozone is a key partner and weakness in this economy will have an effect in the U.S & the U.K. However, I feel as the dust settles and the market analyses the data and the facts going forward, we will continue the trend that we were on before last weeks move with Eur/USD going below 1.20 within the next few months & Eur/GBP going closer to 70p.


  2. PB October 22, 2014 at 7:58 am #

    DT you’ve made a good point. What are your thoughts on EURJPY as we approach year end?

  3. Eamonn O'Connor October 22, 2014 at 8:05 am #

    Hi DT,

    I used to think I was the cynical one! Not sure I believe that the Fed & BOE are that intent on weakening their currencies. However I do admire the strength of your convictions – 1.2000 and .7000 are noteworthy calls.

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