Currency Review

The sovereign debt crisis means there are uncertain times ahead, says Anand Raja of Escape Currency PLC

Uncertainty and volatility have been the dominant themes in the currency markets over the past few months. Sovereign debt crisis in southern Europe, slowing growth in the UK and above target inflation have led to testing times for central bankers and governments alike.

Recent data has shown a marked slowdown in the growth of the UK economy. The government’s decision to implement harsh austerity measures, including an increase in VAT to 20%, has had a devastating effect on UK retail sales. Inflation has consistently remained over 4.5%, which is more than double the European Central Bank target, and has been fuelled by record high commodity prices including oil at over $100 per barrel. The Bank of England has kept base interest near record lows at 0.5% to ensure the UK’s tepid recovery is not derailed. However, low interest rates have a negative impact on sterling.

The eurozone has been faced with an unprecedented sovereign debt crisis. Despite receiving a bailout last July, Greece has again run into financial difficulties. An inability to control spending and an unorganised tax system have led to Greece further widening their deficit. The problems have now spread to more periphery euro countries, including Portugal and Ireland, which have also had to be bailed out. The situation is in stark contrast to Germany which, aided by a weak euro, has a thriving economy driven by production and exports. The European Central Bank has chosen to increase base interest rates by 0.25% twice over the last few months to 1.5%. This is in reaction to inflation running at 2.7%, which is above the 2% target it has set. The recent decision to approve a second bailout to Greece has brought temporary relief to the euro currency.

The GBP/EUR exchange rate has been moving in a 1.10 – 1.14 range over the last few months. This has provided a great opportunity for people looking to bring funds back from Europe to the UK. The eurozone now has a 1% interest rate advantage over the UK which is proving a stiff obstacle for sterling strength. However, the market has yet to decide if the EU solution to the debt problem is sustainable. Should these problems show signs of spreading into Spain and Italy sentiment could quickly change and the euro could come under selling pressure. Volatility is likely to persist and investors should explore products that provide protection.