Why is Pound still high despite UK Recession?

Friday 27th April 2012
Good morning. It’s been a very busy week in the currency markets. In today’s post I will look at the Pound/Euro forecast and predictions for exchange rates in a week that saw the UK heading back into recession. Read my analysis of the effect EU political instability could have on exchange rates, and why the Pound is still strong despite gloomy growth figures showing we are in recession. If you need the best exchange rates, send me a free enquiry for a detailed consultation on the options available to you.

UK back in recession

The UK economy has returned to recession, after shrinking by 0.2% in the first three months of 2012. The technical definition of a recession is defined as two consecutive quarters of contraction. The economy shrank by 0.3% in the fourth quarter of 2011 so the latest figures confirm we are back in recession – just!

The numbers were a surprise to analysts including myself, as most of us expected slight growth of around 0.3%. When the actual figures were released earlier this week, the Pound tumbled across the board, however the fall in rates was very short lived, and have since rebounded.

So despite the fact the figures were slightly worse than many expected, and the fact that the UK is now technically back in recession should not detract from the underlying reality, which is very much as predicted; The UK economy has been bumping along the bottom for more than a year and is still struggling to gain momentum.

So why is the Pound still strong?

This week’s GDP figure is only an early estimate, and is subject to at least two further revisions in the coming months. This is part of the reason why it didn’t have much of an impact. The numbers are compiled using 40% of the data gathered for later revisions, and as it’s only fractions of a percent, the markets haven’t reacted too much to it. This has surprised me.

Another reason the Pound is still strong is the fact all other general economic figures of late have been quite good. This was also underlined this week when UK consumer confidence hit a 9 month high last month. 26% of respondents asked by the Nationwide Building society said now would be a good time to make major purchases, which was the highest level for 10 months. Consumer confidence is a good barometer of overall economic optimism.

Finally, EU political instability has kept the Euro weak and rates supported…

EU political uncertainty keeps GBP/EUR rates above €1.22

One of the main drivers of exchange rates is economic information, of which we have lots to choose from in the last few years! Often overlooked is political instability, but it can have an equal or greater effect. This week we have seen Dutch Prime Minister Mark Rutte tender his government’s resignation, paving the way for early elections.

His cabinet was plunged into crisis when Geert Wilders’ Freedom Party (PVV) quit talks aimed at slicing 16bn euros (£13.1bn) from the budget. Mr Wilders refused to accept austerity demands to bring the budget deficit in line with EU rules. His party was not part of the coalition but supported the minority government. The crisis has also fuelled fears that the Netherlands might lose its triple A credit-rating.

We have also seen some surprise events unfold in the French elections. It was thought that Sarkozy would easily win a majority, but results in the first round of voting suggest otherwise.

So why does political instability in Holland and France affect exchange rates? It’s all to do with investor confidence. A new government in Holland or France may not be as sympathetic to austerity measures as the current ones. Indeed this is likely to be quite a vote winner amongst very low popularity of cuts needed. So with uncertainty surrounding the political future of some major EU economies, it casts doubt on the whole EU bailout plan.

Thus, the instability has weakened the Euro, and kept rates around the €1.22 level despite the UK falling back into recession.

Pound hits 7 month high vs. US Dollar

Sterling rose to its highest level in over 7 months against the US Dollar yesterday, keeping rates well above the $1.60 level, and briefly touching $1.62. It’s quite a surprise to see rates remaining strongly supported, despite the fact the UK is back in recession. So what caused rates to continue to climb? GBP/USD rates have been pushed up by weakness in the US Dollar, as policymakers in the states kept the door open for more monetary easing.

Federal Reserve Chairman Ben Bernanke said earlier this week that U.S. monetary policy was “more or less in the right place” even though the central bank would not hesitate to launch another round of bond purchases if the economy were to weaken. So despite the Pound being in Limbo due to the latest growth figures, weakness in the US Dollar caused by the fact more QE is possible, has made it cheaper to purchase.

Moving forwards, the forecast for GBP/USD rates will depend on events in the Eurozone. With debt problems and political instability giving continued uncertainty to the global economy, and further surprises could cause the Dollar to gain strength due to its safe haven status. When there is uncertainty, investors flock to safe haven currencies like the US Dollar, which can in turn make it more expensive to purchase. Failing any safe haven buying, I think GBP/USD rates will now remain above $1.60

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Have a great weekend. On Monday morning I’ll do my usual weekly retrospective and forecasts.

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