EU Debt crisis & Pound/Euro forecast

Wednesday 13th June 2012
Good morning everybody. We started the week down in the €1.22’s against the Euro, which was supported by news of Spain’s Bank bailout over the weekend. It was hailed as great news for the Euro, and initially the single currency seemed supported. The spin did not last long however, and soon after markets opened the Euro started to weaken again. By yesterday fears that the crisis that has spread from Greece to Spain is now on the way to Italy and Ireland – this caused the Euro to weaken yet again, pushing rates higher.

In today’s post I’ll have a detailed look at the EU problems, the UK’s exposure to them, and what it all means for the Pound/Euro exchange rate forecast.

EU worries push Pound/Euro close to €1.25

Over the weekend it was announced that Spain became the fourth country in the crisis-torn Eurozone to ask for international aid when it was forced to ask for a bailout to prop up a banking system saddled with £150billion of toxic property loans.

The financial markets initially welcomed the deal but investors soon sounded the alarm over the impact the bailout will have on the country’s mountainous debts. On Monday morning everyone was hailing it as great news for the Euro. Hmmmm.

The initial optimism proved short-lived when the markets started trading in earnest on Monday and Tuesday. The Euro suffered considerably as fears over how the money would be funneled to banks hit sentiment, as questions surrounded the terms of the deal, which will add to Spain’s debt burden.

Indeed Spain's borrowing costs have risen to the highest rate since the launch of the euro in 1999, and also Italy's 10-year bond yield rose to 6.28%, a rate not seen since January, as concerns about its finances rose. The interest rates are seen as unsustainable in the long run for two countries weighed down by huge debts. So there could be more bailouts for other countries.

Crisis Spreading to other countries?

While the Eurozone debt crisis has been a cause of concern for some time, it has so far affected relatively smaller economies such as Greece and Portugal. However, as the crisis spreads to bigger nations such as Spain and Italy, there are fears that growth in the region may slow even further.

Cyprus, which is heavily exposed to Greece, hinted it may become the fifth country in the single currency to need a bailout following the rescues of Greece, Ireland, Portugal and now Spain.

It is this spread that has spooked the markets and caused the Euro to fall in value yesterday, getting close to €1.25. So maybe the bailout wasn’t the ‘great news for the Euro’ that the spin doctors had hoped for on Monday morning. Indeed they are, in my opinion, still simply 'kicking the can down the road' and hoping the problem will go away.

Pound remains vulnerable

Following a string of recent weak UK data, a growing number of analysts think the BoE could opt for another bout of asset purchases under its quantitative easing programme, possibly as early as next month. It remains uncertain whether or not the BoE will opt for further QE.

Although the economy is weak, some policymakers have expressed concern that inflation remains too high. But BoE policymaker Adam Posen struck a dovish tone on Monday, saying the central bank should buy assets other than government bonds in order to boost the UK's ailing economy. I for one think we will see further QE, and in fact the IMF and BoE have hinted as much in recent weeks. More QE would weaken the Pound, and of course if the EU debt crisis continues to spread then it will also affect the Pound due to our exports.

What does all this mean for exchange rates?

They key question everyone wants to know is will the GBP/EUR rate keep going up past €1.25 testing new highs, or will it drop back away again as it has now done several times since hitting the 3.5 year high several weeks ago.

One thing I am certain of is that the Euro will continue to lose value. What is impossible to quantify is how the Pound will fare in the shadow of the EU problems. 50% of our exports go to Europe, and of course our banking industry is heavily tied to the EU, so a further escalation of the crisis could start to affect the Pound.

Couple this unknown quantity with the threat of further QE and there is a strong case to be made for the Pound/Euro rate to struggle to make further gains and indeed drop back away.

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Bank of England decide not to pursue QE, for now..

Friday 7th June 2012
Good morning. The markets remain very volatile with the Pound/Euro rate continuing to be pulled in two directions. Only yesterday we saw lows in the €1.22's and highs touching €1.24's, illustrating just how unpredictable things are at the moment. So today I'll take a look at what is pulling the rate; Fears of Spain having debt trouble, and when the Bank of England are likely to pursue Quantitative Easing.

The Bank of England and Quantitative Easing

Yesterday the Bank of England left it's interest rates at 0.5%, and left quantitative easing unchanged at £325bn despite mounting speculation that it would take steps to stimulate growth this month. Before the decision, it looked like around 25% of analysts thought they would pursue more stimulus, and so this was partly priced into the value of the Pound.

When they announced no change for the moment, the Pound then corrected to the upside. If you look at the chart, you can see the instant reaction at 12:00pm yesterday when the announcement was made.

I actually thought there was an outside chance of them announcing further stimulus. Indeed the decision contrasts with the recommendation from the International Monetary Fund (IMF), which last month urged the Bank to restart QE to help restore Britain’s faltering recovery.

I now expect a much higher chance of further Quantitative Easing in July. It's likely that they have simply held off, as should the situation in Europe deteriorate further, they will have this in their back pocket to try and stimulate growth. So, expect a rocky road for Sterling in the coming months.

Spain issues spook the market

There have been reports in the past few days that Spain was seeking an immediate bailout from eurozone funds. I recent weeks I have been warning that behind the headlines about Greece, Spain and other EU countries are facing serious problems. There is every likelihood that the EU will see a domino effect with debt issues spreading.

Spain's economy minister has since dampened speculation that the country is about to seek a bailout of its bank sector, saying that no decision would be made until audits of the banks were completed, possibly by the end of June.

Giving some support for the Euro was strong demand for Spanish bonds at an auction on yesterday, which was seen as a key test of the country's ability to raise funds, but it had to pay a higher interest rate. The rate on the 10-year bonds was 6.044%, up from the 5.743% paid when bonds were last sold in April.

What next for Pound/Euro exchange rates?

I wish I could foresee what will happen, but unfortunately nobody can! On the one hand, the Euro is being pulled down by the well publicised problems with Greece and Spain. I think the Euro will continue to get weaker.

Will the Pound/Euro rate go up though? I don't think it has much further it can go. It peaked several weeks ago in the €1.25's, but speculation on QE in the UK will likely limit any further gains. Being in recession with more QE widely predicted, I can't see where any Sterling strength is going to come from .

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