Forex Investment and Currency Trading

EUR

The EUR has been generally strong in recent months, extending gainsas the market lowers its expectations of ECB easing while simultaneously maintaining or raising expectations of Fed easing. This reflects generally resilient activity data from the Euro-zone, combined with rising inflation and higher wage growth. The ECB is maintaining its traditional hawkish stance and cannot be expected to ease while inflation remains high, wage awards appear to be delivering some sort of “second round effects” from the rise in food and energy prices, and while growth is only slowing modestly. Sub-trend growth will be seen as perfectly acceptable given the need to bear down on inflation.

However, the growth picture is not entirely rosy. Business sentiment in Germany remains reasonable, but this is partly because German companies are benefiting from operations abroad, particularly in emerging markets, which do not add to German GDP. The rest of the Euro-zone is less healthy, with slowdown more clearly evident in Spain in particular, where the housing sector is under pressure. Ultimately, the credit crunch is likely to impinge on lending. Even though lending remains reasonably strong, some of this may reflect distress, as other sources of funding dry up. Although inflation stays high in the short run, the ECB will, by September, be prepared to look ahead to the slowdown likely in 2009 and 2010 and the impact that will have on inflation.

But with immediate rate cut risks evaporating, don’t expect any general weakness in the EUR until well into H2. Remember also that substantial weakness in growth is required to weaken Euro-zone inflation, so the ECB will be targeting a long period of sub-trend growth. Rate cuts are likely to be slow, but extended.

From a valuation perspective the EUR looks a little expensive against the JPY and particularly against the CAD but fairer against most other currencies. If risk appetite evaporates further and we see sharp declines in yields across the world, the EUR would look expensive against the USD as well, but cheap against the AUD and NZD. The sharp rise against sterling and the USD in the last few months have been primarily responsible for EUR trade-weighted gains, and these look set to continue as rates fall in the UK and the US. Over the longer run, rate in the Euro-zone are likely to be falling well in to 2009, after US rates have bottomed, suggesting the EUR will be falling next year.

GBP

Cable has peaked for this cycle and will not regain last November’s 2.11 heights barring some cataclysmic global dollar shock. Once Fed cuts are finished look for GBP/USD to fall more sharply to the mid-late 1.80s. And against the Euro? During the liquidity-fuelled halcyon years of the FX carry trade, sterling was a low vol, high yielding Euro. It is now a mini dollar with falling house prices, exposure to financial services and a wider current account deficit. As long as EUR/USD is going up, EUR/GBP stays elevated as EUR/USD rises further and Cable does not. The pound is in a very difficult place. The next Bank of England rate cut is getting closer. That the MPC voted 7-2 for unchanged rates in March is less noteworthy than who ‘the two’ were. Sir John Gieve joined David Blanchflower in the dove camp, voting for a 25bp cut. The last time this happened last November, the MPC voted unanimously for a cut the following month.

Beyond April, MPC worries over rising headline inflation persist. CPI inflation rose to a nine-month high of 2.5% y/y in February with a sharp increase in energy prices the main source of upward pressure. Risks that the Governor has to write another of those letters to the Chancellor remain. Also, Mr King’s conviction that a period of prolonged sub-trend growth is precisely what the UK needs is deeply held. The Bank of England is not the Fed.

In addition, all the talk of UK hard landing is for now still more perception than hard data reality. Retail sales rose strongly again in February, the second bumper month in a row and is a puzzle given the supposed headwinds facing UK consumers.

None of the above should prevent further monetary easing. While headline inflation is elevated, core inflation fell to 1.22%, suggesting a bit more ‘wiggle’ room for the MPC. On retail spending, the good performance was due to higher food and clothing sales. Discretionary purchases were much weaker. Under any UK hard landing scenario base rates could be cut from 5.25% to 3.5%-4%. UK is among the few economies that has a restrictive monetary policy setting. Something accommodative side of neutral may well be needed.