Sterling falls sharply as Bank of England focuses on growth over inflation
18/Feb/2013 • Currency Updates•
It was generally a quiet week in financial markets, with the conspicuous exception of sterling. GBP continued to march lower versus most major currencies, spurred on by the publication of the Bank of England Inflation Report which had a distinctly dovish bias.
Most other currencies and markets remained range bound. We did see the euro falling somewhat towards the end of the week in response to worse-than-expected GDP numbers in the eurozone. This could be a sign that investors are starting to focus on macroeconomic fundamentals, which would not bode well for the euro over the next few weeks.
The big event of the week was the publication of the Bank of England Inflation Report. The MPC did not disappoint markets. Large upward revisions were made to the entire inflation forecasts, and CPI is expected to remain above target two years from now at 2.3%. In spite of this overshoot, Mervyn King made it clear that the Bank of England will remain extremely accommodating, and stated that the MPC stands ready to provide more stimulus.
Clearly, the existing framework for monetary policy is being thrown out given persistent weakness in growth. Once Mr. Carney takes over Mr. King’s position, we can expect this process to accelerate. Markets reacted by sending sterling sharply lower, and GBP ended the week down between 2% and 3% against all major currencies.
Last week brought about yet another dismal batch of macroeconomic figures from the eurozone. What was different this time is that FX markets seemed to take note of them, as the euro erased its gains to end the week slightly down against the dollar.
GDP contracted by a worse-than-expected 2.3% saar last quarter. This average, however, hides some catastrophic performance in peripheral countries. Spain saw GDP shrink by 2.8%, Italy by 3.7%, Portugal by 7.2%, and Greece by a fantastic 16%. Five years into the crisis, not a single peripheral economy, with the possible exception of Ireland, is anywhere near touching bottom, let alone showing signs of rebounding. The recent strength in the euro couldn’t come at a worse time for these economies.
We expect the ECB to join the Bank of England and the Bank of Japan soon in trying to talk down the currency, and expect that next week revisions to the ECB forecasts will be far more pessimistic than the consensus expects.
Focus in the US is switching to the so-called “sequester” Federal spending cuts and their potential impact on growth. Sequester cuts refers to the automatic cuts in spending that were postponed by two months in the January 2nd agreement. Unless Congress and President Obama agree on legislation by March 1st, these automatically will take place across the board.
We are still confident that some sort of last-minute agreement will take place. In any case, the relative resilience in retail sales in spite of the payroll tax hike that went into effect January 1st gives us some confidence that the US economy is getting enough lift from the housing recovery and the external sector to weather the cuts relatively unscathed.
We are pencilling in a growth rate of 2.5%-3.5% for 2013, assuming that the sequester cuts are prevented. If they are not, we would lower our forecast to 2-3%. This represents a relative outperformance versus most other major economies, and we therefore expect the dollar to trend up throughout the year.