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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