Sterling falls to multiyear lows after UK sovereign downgrade

Tom Tong25/Feb/2013Currency Updates

The spotlight last week was once again on Sterling. The pound had yet another terrible week, falling against just about all major currencies. The publication of dovish Bank of England MPC minutes and the news that Moody’s had downgraded UK’s sovereign rating hammered GBP.

The Euro also had a difficult week, falling sharply against the dollar and most major currencies except, of course, Sterling. FX markets are clearly starting to focus on macroeconomic fundamentals, so the drop in European currencies against the dollar is no surprise. However, we think that Sterling weakness is becoming a bit overdone, particularly against the Euro.

GBP

The MPC shook the markets last week. The minutes of its February meeting made it clear that further expansion of quantitative easing is increasingly an option, as King and Fished joined Miles in voting for an increase in the Gilt purchase target. The minutes also called for a more coordinated response to the crisis, which we interpret as a call for a rethink of Mr. Cameron disastrous austerity policies.

Sterling reacted badly both to the MPC meetings and Moody’s downgrade of the UK sovereign credit to AA from AAA, dropping by over 2.0% against the dollar and by 0.5% against the Euro. Ironically, last week saw the publication of some puzzlingly positive macroeconomic news, as the ILO labor report revealed that employment grew robustly in the last quarter of 2012. The dichotomy between fairly positive job creation and dismal news elsewhere in the economy has yet to close.

EUR

The PMI business sentiment indices out of the Eurozone last week underlined the dismal macroeconomic prospects in the region. The composite index dropped 1.3 points to 47.3, firmly in contraction territory, and disappointed the hopes that some had placed on its apparent stabilisation over the past few months.

There were the usual sharp divergences in the report between Germany and the periphery. The French news were particularly distressing, as the French economy seems to have started down the path trodden by peripheral economies since 2010: a vicious downward spiral as disastrous austerity policies feed into business confidence, unemployment and the Government deficit, triggering further cuts and tax hikes.

Financial markets are clearly focusing again on the differing macroeconomic prospects between the world’s economic regions, and it is not surprising that the Euro fell sharply against almost every major currency except Sterling.

USD

Mostly second tier macroeconomic reports last week were generally positive in the United States Housing data revealed that the housing recovery is fully on track, as further signs emerge of a developing shortage in housing, brought about by the lack of construction since the crash.

Focus now shifts to the “sequestration” cuts, the set of automatic spending reductions built into current law unless the Republican-controlled Congress and the White House agree to avoid them. The situation is as silly as it sounds, and therefore we expect that an agreement will be reached, probably shortly after the deadline, just like January. Even if no agreement is reached, the cuts will be at most 0.6% of GDP, and Congress available wiggle room mean that they will probably be closer to 0.4%.

Therefore we think that the continued recovery in housing and private business investment will be sufficient to keep US growth on track. The trend towards a stronger dollar has further to run.

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Written by Tom Tong

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