Looking at the fundamental economic principles affecting both currencies and assessing the extent to which current events will affect future rates, I will try to determine the best course of action for anyone selling or buying Euros to take and more importantly perhaps be prepared to take.
Inevitably the figures below which detail where I think GBPEUR will be at 3 monthly intervals for the next year will change, but having been asked a longer term prediction on the market by a new client I have put my neck on the line here today. I feel it is good for our readers to read something a bit longer term. I hope you enjoy this and as always encourage you to contact me with any questions or enquiries at firstname.lastname@example.org I have never been beaten on an exchange rate for a client and am confident I can save you money.
All too often overlooked by anyone interested in currency transfers. The interest rate of a central bank will affect the strength of a currency. In a similar fashion to the way a higher interest rate will attract savers to a bank account, a higher or lower interest rate by the central bank will affect investor demand for a currency. In this case I am referring to for the pound, the BoE (Bank of England) who’s MPC (Monetary Policy Committee) decide on whether to raise or lower interest rates at the start of each month. For the Euro we look to the ECB (European Central Bank) chaired by Mario Draghi who also meet monthly to decide on changes in their central bank rate. Changes in the central bank lending rate affect the economy and in the current economic climate all central banks have their interest rates exceptionally low to foster growth.
The effect of interest rates on a currency pairing can be huge. July last year GBPEUR was at 1.1067 on the interbank rate. This was a result of the ECB hiking interest rates twice at 0.25% that year from 1% to 1.5%. This caused the Euro to make major gains against most currencies but was questioned by many commentators as to whether or not it was wise given the instability in markets. Fast forward to the end of 2011 and Mario Draghi, the new ECB President came into power. He immediately cut Eurozone interest rates twice at the end of 2011 which is when the rate started to weaken and we moved towards the 1.20 mark. It is not the sole reason for movements but it is a huge underlying reason.
The last ECB rate decision we saw action on rates was July where we saw the Euro suffer colossal losses amidst debt fears and we hit 1.2860. Interest Rates and central bank policies are one of the major determinants on exchange rates. It explains loosely why ‘rates are where they are’. Sometimes referred to as the interest rate differential, the difference between two currencies central bank interest rates goes a long way to explaining where we are on rates. And we can look ahead and use anticipated policy to guess where rates will be in the future.
Central Bank Economic Policies
Economic policy by a central bank is not just interest rates. Central banks also have the power to intervene in bond markets. Every government sells bonds (a promise to pay someone in the future) to pay for day to day expenses of running a country. These bonds are auctioned off regularly and taken up by investors who are paid a return according to the risk. Spain is a higher risk than the UK, so investing in Spanish bonds yields a higher return than UK bonds which are seen as safer. To ease the financial wheels in an economy the central bank may choose to buy up these bonds under programmes known as QE, Quantitative Easing. QE has become a major feature of current global economic policy. It is a shot in the arm to an economy and whilst its effects are heavily debated it seems to be loosely accepted that it helps the economy.
In Europe the ECB have not embarked on QE because it is not within their remit. The ECB’s remit is to keep inflation low (price stability) whereas the BoE seek to control Financial Stability and the Federal Reserve in the US seek (amongst others) full employment. Because of the way the Eurozone is setup the ECB does not intervene in the bond markets in the same way as the UK or US do. However recently a major change in economic policy by the ECB was heralded by Mario Draghi, who announced there would be ‘unlimited’ bond purchases for indebted nations who met certain criteria. This is what has served to strengthen the Euro lately. Other interesting comments by the ECB are that the Euro is ‘Irreversible’ and Mario commenting that he and the ECB will do ‘whatever it takes’ to save the Euro. I draw from this that Greece will not be leaving the Euro anytime soon and that we will see yet more action by the ECB to back up all members as required. This has caused the Euro to regain much strength and whilst the rate cuts and debt crisis uncertainty are keeping the rate weak relative to last year, it is this sentiment which could provide further gains for the Euro.
The UK is due more QE before the end of the year and the historic effect of QE is to weaken the currency concerned. However where QE was once a dirty word, it is now seen as necessary due to the tough global economic conditions we see. i.e without it the UK would be in a much worse position. It will take years, decades before we know the true extent but some reports by the BoE suggest QE has added between 0.5 and 2% to growth in recent years. QE historically always weakened a currency because it increases the money supply and as an unconvential measure to stimulate growth is not seen favourably by investors. Its effects on the pound may indeed be already priced into the value of sterling and a UK rate hike seems a very long way off. But eventually I expect that the UK will need more and it will keep the pound weak. Conversely such action by the ECB caused Euro strength as it was seen as restoring confidence. Please note the ECB action is not ‘QE’, but it is an interventionist policy, particuarly for the ECB, which historically has not taken such steps.
I feel therefore that the chance of any interest rate hikes by the ECB or BoE can be ruled out for the time being. It is unlikely we will see the Eurozone do anything before the end of the year with so much having happened so far this year. But we could possibly see another rate cut which would weaken the Euro. An interest rate cut also lowers the exchange rate to which you could expect any improvements in circumstance to take you to. The current interest rate differential means it is unlikely you would return to anything sub 1.20 in my mind. Of course you could potentially see rates go right down sub 1.20. I do feel however that three interest rate cuts in less than a year limits the amount other factors could cause the rate to move lower.
Debt crisis and Growth
Put bluntly something needs to be done to foster growth in Spain, Italy and Greece. Extra money via the bond purchases is great but something needs to be done to allow these countries to grow. The bond purchases provide breathing space for these economies to grow but until the economic data impresses, many will continue to be pessimistic. Things are getting worse for the time being. More and more political uncertainty is surfacing and it is this that could really stoke another Euro sell off. Whilst I wholeheartedly note that even in Greece no serious anti austerity party has found a majority, the fringes are gaining support and this could become more problematic.
I like most cannot see in this current market what is actually going to be done to solve the crisis and it is this uncertainty that is prepetuating Euro weakness. And it is this lack of confidence that is sapping the global economy. Pressure will intensify on Eurozone leaders to act and we may see more smaller term measures to provide liquidity and boost confidence in the markets. These may include LTRO (Long Term Refinancing Operation) an ECB operation to provide longer term loans to Eurozone banks. Things have settled for a time but longer term I just cannot see how we won’t see serious concerns creep back into the market.
Sometimes termed the ‘Two Ugly Sisters’ as it is often a case of which is the least favoured by investors. The most heavily traded currency pairing globally. The inflow and outflows of currency between these two causes movements on GBPEUR and GBPUSD. EURUSD is affected by risk sentiment and attitudes to risk by investors. Quite simply when there is lots of fear and uncertainty in the market the USD will strengthen. It is referred to as a safe haven currency because it is the most widely circulated currency and is represented in a huge amount of investor portfolios. Because of its relative size and certainty plus the strength of its economy, in times of uncertainty USD is bought. Lately times of uncertainty equate to Eurozone instability. When there is confidence in the markets, like for example following the US QE decision last week, you will see investors leave the USD to invest in what are relative to the safety of the USD, riskier assets like the Euro, but also the Aussie dollar, Kiwi Dollar and perhaps stocks and shares.
These inflows and outflows on EURUSD according to prevailing risk sentiments affect the relative strength of the Euro and Dollar against other currencies including GBPEUR.
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My 12 month GBPEUR forecast is as follows:
3 month Forecast – 1.2225
6 month Forecast – 1.2056
9 month Forecast – 1.2465
12 month Forecast – 1.2845
Sterling Weakness or Euro Strength?
To summarise I feel the Euro will remain under pressure but feel the ECB have done enough for the time being to keep Spanish and Italian bond yields lower and to keep investor fears over a break up of the Euro at bay. Spain will probably be forced to accept a bailout but I think this should strengthen the Euro once it is finalised (as it removes the uncertainty – notably it is this uncertainty [over Spain] – which I feel has caused recent GBPEUR movements and which is why I do not expect this current spike to last). Some more QE for the UK perhaps towards the end of the year will weaken sterling alongside poor UK data. The lack of any Olympic Effect and the fact Construction, which has been central to UK economic growth in recent years is faltering, puts back the chance of any UK interest rate hike and increases the likelihood of more QE next year for the UK. Result in my opinion? Yet more sterling weakness.
These factors could I believe provide the right opportunity for you in the next few weeks and months. I think a target of 1.20-1.22 is realistic in the next 6 months subject of course to the right conditions. Investors patience over Europe is bruised and battered, earlier in the summer negative UK data had almost no impact on rate and if the wave of confidence that did sweep the Euro disappears, you could easily see things spiral. But looking to history in the last few years, the rate has majorly see-sawed. Mervyn King (Governor of the BoE) referred to this as a ‘Zig-Zag’ recovery and I am inclined to believe that we will see more zig-zags on the rate. The weakness of the economic recovery in the UK is by no means strong enough to support a full blown recovery towards the rates of post 1.30.
Strangely enough the Eurozone crisis could work against the rate since the UK economy relies heavily on trade from Eurozone members (about 40% of UK overseas trade).The lack of orders from European businesses could cause sterling to lose ground against the Euro.
The unknown nature of exchange rates makes forecasting and strategies very difficult. In my experience it is about being reactive to certain conditions. I would set some loose boundaries on what you want to achieve. Feasibly Greece could withdraw from the Euro overnight along with Spain and other countries which could cause the Euro to top 1.30. What would you do? This may be a difficult question to contemplate but running through it at least in your mind could save you money. The outlook will change almost daily on currencies as new and unexpected political and economic factors are brought into the mix.
Two contract options I suggest are Stop / Loss and Limit orders. These allow you to choose a level you would trade at which is currently unachievable. A Limit is a better rate than currently achievable, say 1.23 and a Stop / Loss is a worse than rate, say 1.28. Due to the volume it may make sense to hedge your risk and sell off the currency in chunks. No clear direction is really being established on the rate and therefore it may be wise to take advantage of spikes at different levels. It is all relative in the end but setting now some targets may aid your decision making process.
Another very useful tool is a Forward Contract. This allows you to book current levels forward for a future date. If buying or selling a property or looking to pay a bill in the future, reserving a rate now means you know exactly how much it will cost you when the time comes.
I deal with many in the financial industy who’s job it is is to trade the markets and even they do not get the absolute ‘top’ or ‘bottom’ of the market. It sounds to me like you have plenty of time which is good, there is always value in holding out in case things go in your favour.
Getting the best rate is about looking at where the rate has been, reacting to new developments and an awareness of what is driving the rate. To sum up, I feel the Euro will make further gains against sterling but that they will ultimately be shortlived.
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