Market confidence in the build-up to last week’s EU Summit
was pretty much at rock bottom. Angela Merkel’s continued tough stance on
eurobonds seemed to indicate a wider deadlock between Germany on one side and
struggling eurozone nations such as France, Spain and Italy on the other.

In the early hours of Friday morning, EU chief Herman Van
Rompuy announced several decisions which gave risk appetite and market
sentiment a major boost. Two key questions left by the Spanish bank bailout
deal were answered. First, the bailout funds will be able to directly
recapitalize Spain’s banks, without adding to the debt-to-GDP ratio of Spain as
a whole and forcing its borrowing costs up. Second, the bailout loans will not
be given senior creditor status, easing concerns that private bondholders will
not see their investments completely written off. In addition, pledges were
made that the bailout funds will be able to invest in distressed bonds
directly, again relieving concerns around the Italian and Spanish bond markets.

Clearly the markets were impressed by these decisions and
they certainly buy some more time but they don’t amount to a silver bullet
solution to the debt crisis by any stretch of the imagination. We still lack
any detail on the fundamental issue of longer-term fiscal union and whilst the
bailout resources can be used more flexibly now, though its size remains
inadequate.

ECB and BoE both set to
make moves this week

ECB Chief Economist Peter Praet stated recently that “there
is no doctrine that interest rates cannot fall below 1 percent.” Comments such
as these lead us to believe that the ECB is set to cut its already record-low
1.00% interest rate to 0.75%. There is a significant risk that the ECB will cut
rates to 0.50%, in light of weak eurozone growth data and fading inflationary
risks. Whilst the market is likely to be grateful that the ECB is taking
action, the reduction in the euro’s interest rate differential is likely to be
a negative for the single currency in the longer-term.

We expect the Bank of England to introduce further
quantitative easing on Thursday, in light of the distinctly dovish tone within
last month’s MPC minutes and the four votes in favour of QE that they revealed.
Only one more dovish voter is required for a majority in favour of QE and we
believe this will come on Thursday. The move looks to be fully priced in
though, so sterling has already taken the pain in relation to this move.
Wednesday’s UK services figure will be watched closely on Wednesday, a slowdown
is expected.

End
of week forecast

The dollar has suffered a significant sell-off amid booming risk
appetite in the aftermath of the EU Summit. We maintain a bullish outlook for
the US dollar moving forward, although the week ahead brings with it
significant risks. Friday’s US non-farm payroll is expected to show a mild
improvement but amid the softness in US growth data of late it would be no
surprise to see the result undershoot expectations.

The euro’s rally has already run out of steam; GBP/EUR is
trading up above €1.2450 and EUR/USD’s has pared back from $1.27 to below
$1.26. We continue to target levels well above €1.25 for sterling. A further
decline in the EUR/USD pair will surely weigh on GBP/USD, which is coming up
against stiff resistance around $1.57.

The market has been to the brink several times before in the
case of Greece and the euphoria in response to the Greek election result was
understandably short-lived. Certainly the worst-case scenario – a victory for
the leftist Syriza and a potential euro-exit- was avoided but investors know
full well that Greece’s second bailout will not buy sufficient time for Greece
to get its house in order in a permanent sense, so the country’s painful saga
continues.

Spain is very much in the headlines at present, as the
country’s 10-year bond yields have broken through the dreaded 7.0% level which
has forced other eurozone nations into bailout requests. Spain has already
reached an agreement for a €100bn bailout of its banking sector, but these
borrowing costs could ensure the sovereign itself will be requesting a bailout
before long. The delay to the second part of the audit of Spain’s banks until
September has not helped sentiment one bit, with suggestions being made that
Spain’s bank could need more than €100bn.

Germany is likely to be the next country to dominate the
headlines, though unsurprisingly not due to economic weakness or high debt
levels. June 29^th will see the German parliament vote on the EU
fiscal treaty and the creation of the permanent eurozone rescue fund. Any
indications that Angela Merkel is losing her grip on power domestically are
likely to weigh on the euro significantly. Nonetheless, Merkel is widely
expected to prevail in the vote.

Sterling firm ahead of
MPC minutes release

Tomorrow’s MPC minutes will reveal the voting pattern
with respect to the introduction of further UK quantitative easing at the MPC’s
June meeting. Today’s weak inflation data has already made the domestic
environment a more QE-friendly one, though we look back to last week’s Mansion
House for indicators that the majority of the MPC will have different ideas.
King announced an £80bn ‘funding for lending’ speech, which suggests the BoE
are looking at alternative ways of boosting UK growth.

This week also brings US Federal Reserve monetary policy
into sharp focus, with the central bank meeting and giving its statement and
economic projections on Wednesday. Increasingly weak US growth data has
pressurised the dollar of late but we continue to bet that the Fed will hold
fire for now.

End
of week forecast

Having dipped as low as €1.2270 last week, GBP/EUR is now
trading at €1.24, which is a reflection of the market’s muted response to the
Greek election. We remain confident that we will see May’s highs just below
€1.26 before long, though developments in Greece and Spain could have the final
say about just how soon this will be.

Sterling is trading at $1.57, thanks to fears that the Fed
is edging towards QE3. The current retracement in the EUR/USD pair is not
something we see being sustained much past $1.28, which leaves upside potential
from the current $1.2660 level as pretty limited.

Growth-wise, eurozone data over the past fortnight has
pointed evermore towards a dip back into negative territory in Q2 of 2012.
Pressures are still very much being felt in the bond markets, with Spanish
10-year notes yielding almost 6.50% and Italy’s equivalent debt yielding almost
6.00%. Last week’s policy announcement from the ECB was notable in revealing
that the central bank is reluctant to cut interest rates from the current 1.00%
level. Perhaps more importantly ECB President Draghi is unwilling to step in
and buy bonds on the secondary market. The ECB has made it clear that it will
not fill the void left by the EU’s dithering leaders.

With Spain’s short-term pressures easing somewhat, the Greek
saga comes back into view. This Sunday (June 17^th) brings the Greek
parliamentary elections, where there remains a significant risk of an
anti-bailout coalition emerging. Feasibly, we could see another stalemate and
another election called. The situation is incredibly uncertain and looks set to
put the market on edge as the event draws closer.

Bank of England decides
against QE, for now

Last week saw the Bank of England’s MPC decide against
introducing another round of quantitative easing in June. The threat of more QE
has been weighing on sterling of late, particularly amid a slew of weak UK
growth figures. However, a surprisingly solid UK services figure may well have
given some of the MPC policymakers the resolve to hold off on voting for more
QE last Thursday. The minutes from the meeting, released next Wednesday, will
clearly be very revealing on just how close the MPC’s call on QE was. For now
though, sterling looks set to find some favour – it’s safe-haven status should
be able to return to the fore as the Greek elections close in.

Elsewhere, US data has continued to point to a slowdown
in recent weeks, though Ben Bernanke was unwilling to provide any clues as to
the introduction of QE3 any time soon, which is dollar-supportive. He stressed
the risks posed by the eurozone debt crisis to the US economy but his rhetoric
smacked of a willingness to ‘wait and see.’

End
of week forecast

Sterling is trading at €1.24, with the euro having totally
given back the gains it made on Sunday night as a result of the Spanish bailout
progress. Nerves look likely to intensify ahead of the weekend’s Greek
elections and as investors contemplate the possibility of a Greek exit from the
eurozone once again, we are looking for sterling to climb back up towards €1.25
in the coming sessions.

Likewise we are looking for lower levels for EUR/USD. The
euro’s relief rallies are proving more and more flimsy now as the debt crisis
goes on. Another look at $1.24 is a distinct possibility, but for now it trades
a cent and a half higher. A weaker EUR/USD pair will inevitably weigh on the
GBP/USD pair, which currently trades at $1.5530. Whilst we believe sterling should
be able to take a decent share of the safe-haven flows this month, we still
view anything above $1.55 as a bit lofty.

The basket case that is Greece has dominated the
financial headlines in recent weeks. The country’s May 6^th elections
saw the ruling pro-bailout coalition fail to secure sufficient support from
Greece’s angry electorate. This ushered in a month of huge uncertainty as the
market looked ahead to another Greek election on June 17^th; with
speculation growing that Greece’s anti-bailout parties would curry enough
favour to form a coalition. The logical result of a rejection of Greece’s
second bailout agreement would be default and an exit from the euro, so it
should come as no surprise that the euro suffered further declines.

The pound was a key beneficiary of these euro declines,
despite the negative implications that the eurozone debt crisis has on the
already dire state of the UK economy. Recent data not only confirmed that the
UK entered a double-dip recession in Q1, but it contracted by 0.3% rather than
the 0.2% initially estimated. Taken with April and May’s growth figures, which
are pointing to a soft start to Q2, this has unsurprisingly triggered fresh
speculation that the MPC will edge back towards introducing more quantitative
easing in the second half of the year. We are doubtful in this regard, for now.

Sterling is trading at impressive levels against the euro
and despite a period of profit-taking in the past week or so, it remains at
strong levels against the majority of global currencies thanks to its safe-haven,
euro-alternative tag. However, as usual there is one currency sterling can’t
outperform in the strongly risk averse trading conditions that characterised
most of May – the US dollar. The dollar has helped itself to some easy and
significant gains across the board as the eurozone debt crisis forces market
players to unwind their riskier positions in favour of the safest of assets.

GBP/EUR

Sterling remains firm and continues to threaten higher
climbs against the euro, as conditions in the eurozone go from bad to worse.
Uncertainty, as ever, is the buzz word. The pro-bailout New Democracy Party has
edged ahead in the Greek opinion polls, which has lifted market hopes that the
country can receive the additional funding it needs and remain ‘safely’ within
the eurozone.  But there is plenty more debate to be had in Greece and few
will be truly confident of a positive result ahead of the fresh elections on
June 17^th. Yet another Greek election is a distinct possibility.

The chances of a messy ending to the Greek saga remain
very high. Even if a pro-austerity, pro-bailout coalition does emerge out of
this month’s elections, they will still have to find a way to deliver the major
reforms and deficit reduction that the country’s €130bn bailout agreement requires
– no mean feat. The EU Commission has recently reminded Greece that its bailout
payments remain highly contingent but whoever wins this month’s elections, you
can expect some desperate efforts to have the bailout terms relaxed to a
significant degree.

Spain rings alarm bells

Greek concerns, though likely to return to the fore as
the elections draw closer, have been put on the back burner for the time-being.
True to form, another struggling eurozone nation has stepped up to fill the
void – Spain, or more specifically, Spain’s banking sector.  Bankia,
Spain’s fourth-largest bank, requires €19bn worth of recapitalisation and it is
becoming more and more apparent that Spain will need help to shore up its
banking sector as a whole. The issue is having a significant impact on Spain’s
government borrowing costs, with 10-year bond yields climbing dangerously
towards the unsustainable 7.0% level. As ever with this debt crisis, market
fears build so much that they tend to become a self-fulfilling prophecy. In short,
Spain is in very serious trouble and its government has admitted as much –
requesting EU help with bank capitalisation. This is no minor development given
that Spain is the eurozone’s fourth-largest economy and emergency help for
Spain will inevitably turn the market’s gaze towards the third-largest – Italy.

UK economy still looks
frail

The UK economy is looking particularly downbeat at
present, having been hit with the confirmation that it is firmly in double-dip
recession territory. Unsurprisingly, consumer confidence has taken a sharp
downturn and weakness in UK growth figures has become alarmingly consistent.
The last update from the UK labour market was a little more encouraging but we
will need to see more than one good month before hoping for sustained
improvements.

Amid all of this bad domestic economic news, as well as
the grave threats posed by the eurozone debt crisis, it might be assumed that
more quantitative easing is bound to be introduced by the Bank of England in
order to drag the UK out of recession. Certainly the IMF has made its views
known on the issue, encouraging the BoE to act soon to safeguard the UK
economy.

However, the noises out of the MPC have not suggested
that such a move is imminent, despite the recent sharp decline UK inflation
from 3.5% to 3.0%. A key reason for this is that the BoE sees UK inflation in
the medium term as equally likely to exceed its 2.0% target as undershoot
it.  In addition, Spencer Dale has recently stressed the argument that the
recent quantitative easing doses are still feeding through to provide stimulus
and that a further round is not appropriate at present. This position is
supported by the recent improvement in UK money growth.

With only one MPC policymaker voting in favour of QE at the
MPC’s May meeting, in the form of David Miles, there is plenty of dovish
recruitment to be done in the coming months if the BoE is to pull the trigger
again on further monetary easing. Sterling seems safe in this regard for June
at least, though eurozone risks could feasibly escalate sufficiently to prompt
BoE action in July or August.

Euro to weaken further

So, despite the UK economy sitting uncomfortably in a
double-dip recession and facing a prolonged period of stagnant growth and
ultra-low interest rates, sterling looks free to continue taking advantage of
an increasingly euro-negative environment. Some major steps towards EU fiscal
union will be required to ease market sentiment, and the obstacles to this are
all too clear.

Sterling/euro hit heights of €1.2575 in mid-May but has
come off those highs to the current level of €1.24. We envisage further gains
for the relative safe-haven pound in June, with the Greek elections and rising
Spanish bond yields providing plenty of motivation to exit the euro. €1.26 is a
realistic target in the coming few weeks.

GBP/USD

Whilst sterling has enjoyed something of an easy ride
against the troubled euro, against the US dollar it has been an altogether
different story. Again, market uncertainty best explains the US dollar’s
stellar performance in May. It’s fair to say that the market is in a state of
panic at the moment, concerned with a ‘Grexit’ and most recently a ‘Spexit.’
Amid such monster question marks, there has been widespread flight to the
safest assets such as the US dollar. Sterling may be markedly a safer
alternative to the single currency, but its safe-haven status cannot compare
with that of the greenback.

The rug has finally been pulled from underneath the
EUR/USD pair. The scale of the eurozone’s current problems is now being
reflected in the price of the euro; EUR/USD has declined by over 5.0% from
$1.3150 to $1.25 in the space of just one month. We do see the EUR/USD pair
considerably lower in the coming months, which will inevitably weigh on the
GBP/USD pair.

The US dollar is not without its own domestic economic
concerns, with recent data confirming that the US economy grew at an annualised
pace of 1.9% in Q1, down from the initial estimate of 2.2% and well down from
Q4 2011’s 3.0% pace of growth. Progress in the US labour market has also slowed
right down, which has once again seen speculation that the US Federal Reserve
will introduce QE3 step up a gear. Whilst the US economy is stalling as we
enter the summer, it is still firmly in recovery mode. We continue to hold the
view that the Fed will want to gather more evidence about the US recovery’s
direction before pulling the trigger on more quantitative easing, so we view
the current QE3 concerns as over-hyped.

Safe-haven dollar to
outperform

Sterling has recently revisited January’s lows below
$1.53, having suffered a 6.5% drop against the US dollar in the space of just
four and a half weeks. Sterling has finally bounced against the US dollar and
is currently trading at $1.55, but we think this will prove temporary. A
consolidation period was always likely after such a steep drop, but we should
see lower levels tested once this current bout of profit-taking on the dollar’s
recent rally has run its course. Lower levels in the $1.51-1.52 area could well
be seen in June as the negative eurozone headlines once again take their toll.

Caxton FX one month forecast:

It is estimated that the Royal Wedding in 2011 weighed on
the UK’s gross domestic product (growth) by 0.4%. An extra bank holiday means
businesses are closed for longer – economic activity is reduced. Of course,
there is likely to be increased spending on the high street and a boost to
industries such as leisure and hospitality. This will certainly compensate for
some of the impact on UK growth, but not all of it.

The Jubilee looks set to weigh on growth by 0.3 – 0.6% again
this year, which is the last thing that the UK’s struggling economy needs right
now. Data last week confirmed that not only did the UK economy contract for a
second consecutive quarter but by even more than expected (-0.3% q/q). With the
Jubilee set to constrain quarterly growth which was only ever likely to be flat
at best, we can expect third consecutive quarter of negative growth.

What does this mean for sterling? Well, it won’t necessarily
hurt sterling. After all, last week saw the release of some awful UK retail
sales growth data, some much weaker domestic inflation data and a downward
revision to the Q1 UK GDP figure. Regardless, sterling performed strongly,
thanks to the ongoing focus on all things eurozone and the risk averse,
sterling-friendly trading conditions this is creating.

Of course the risk remains that more negative growth will
convince the MPC that more quantitative easing is necessary, but as yet the
majority of the nine policymakers seem happy to let the last round of QE to
feed through, particularly with medium-term UK inflation risks well-balanced
and present inflation levels still elevated.

One common ‘silver-lining’ lining argument is that while the
Jubilee may hurt Q2, the London Olympics are only just around the corner in Q3.
Estimates have surfaced that the spending linked to the Olympics will boost UK
GDP by 0.5%. We approach these predictions with a great deal of caution though,
as do the Bank of England, since the impact and success of mega-events such as
the Olympics are highly unpredictable. Sydney 2000 boosted Australia’s economy
considerably, while Athens 2004 left the Greek economy crippled.

We maintain a positive view for sterling this year, except
against the US dollar, regardless of stagnant/negative growth. Clearly the
caveat here is that the picture may change if growth is so poor that the BoE pull
the trigger on more QE – a major downside risk for sterling. Looking at the
limited impact of the last round of QE on sterling though, there is a good
chance sterling will hold up firmly again.

The euro was given some relief in early Monday trading by
the positive news that in Greece, the conservative and pro-austerity party – New
Democracy – has edged ahead of the anti-bailout party Syriza in the opinion
polls. If New Democracy can hang on to their lead and re-establish a
pro-bailout, pro-austerity and pro-euro coalition, then fears of a Greek exit
should subside. Judging by the euro’s brief and fairly minor bounce since the
weekend though, the market remains understandably cautious.

Concerns over Spain are also growing, as the country’s ten
year bond yields climb towards 6.50%, bringing into view the dangerous 7.0%
benchmark which forced other peripheral nations, like Portugal and Greece, into
requesting bailouts. Spain’s fourth-largest lender Bankia requires a bailout
and the Spanish region of Catalonia is also in need of help to refinance its
debt. Consequently, the risks of a Spanish sovereign bailout are increasing,
which would create a huge amount of stress on the EU’s aid resources, as well
as raising major question marks over Italy.

In addition to these mounting Spanish concerns, growth data
from the eurozone was all pointing the wrong way last week. Figures from the
German, French and eurozone-wide services and manufacturing sectors almost all
disappointed, suggesting that the eurozone’s avoidance of economic contraction
in Q1 will prove temporary.

With respect to the issue of Eurobonds, Germany doesn’t look
like it will budge. What’s more, Austria, the Netherlands and Sweden have
joined Germany in expressing their opposition to the idea of common eurozone
bonds, so market hopes for a silver bullet have once again been quashed.

US GDP figure should confirm slowdown

This week brings two important growth figures from the
US, in the form of the revised GDP estimate for the first quarter of 2012 (due
on Thursday). The figure is expected to be revised down from 2.2% to 1.9%, well
off Q4 2011’s impressive quarterly reading of 3.0%. Friday brings the monthly
update from the US labour market and improvements in this area are expected to
be moderate at best.

The US dollar’s safe haven status has very much come to
the fore in the past month. Clearly ongoing softness in US figures keeps QE3 on
the table as far as the Fed is concerned but we see safe-haven demand helping
it appreciate further across the board. In particular, we foresee heavy losses
for EUR/USD in the second half of this year, which will inevitably drive
GBP/USD lower too.

End
of week forecast

Sterling is trading up above €1.25 this afternoon, with the
positivity surrounding the Greek opinion polls already having dissipated.
Sterling weathered some awful data last week, including a downward revision to
the UK’s Q1 GDP figure to -0.3% and a steep drop in the domestic inflation
rate. However, sterling’s safe-haven status still looks likely to push it even
higher against the euro.

In contrast, sterling is always going to be under pressure
against the US dollar. It should benefit from a minor short-covering bounce
soon, though a return anywhere close to $1.60 looks a stretch now. Risk
appetite away from the US dollar is likely to be hard-pushed to return in force
ahead of the June 17^th Greek elections.

The week ahead brings with it plenty of risks for sterling. Wednesday’s
minutes will bring BoE monetary policy back into focus – all eyes will be on
how the MPC voted on QE in its May meeting. David Miles is likely to have stuck
to his pro-QE stance and one or two others may well have been convinced by his
arguments, which would be sterling-negative. Comments from the once reliably
dovish Adam Posen have also added to QE bets. Posen publically questioned the
wisdom of his decision not to vote for QE at the MPC’s May meeting, suggesting
he can be counted on to do so again in coming months. Inflation data on Tuesday
is highly likely to reveal that the headline rate has come down pretty sharply,
once again bolstering arguments in favour of monetary easing.

Also on Wednesday we have the release of April’s growth data
from the UK’s retail sector. Having seen the wettest April since records began,
the figure is expected to show a fairly sizeable contraction, particularly
after the excellent growth seen in March. Thursday brings the revised UK GDP
figure for the first quarter of this year. No amendment from the initial
estimate of -0.2%, so the figure is unlikely to be a source of great support
for the pound.

On the face of it then, it looks to be a tough week ahead
for the pound. In addition to these domestic announcements, risk appetite away
from safer currencies such as sterling looks to be staging a minor recovery.
With the potentially disastrous effects of a Greek euro-exit now sunk in, if
not fully priced in, we may well have seen the worst of investor panic. That is
of course until the Greek elections come into view in the build up to the June
17^th Greek elections. Sterling’s safe-haven demand looks set to come
back to the fore ahead of this huge risk event.

G8 pledge support for
Greece to remain within euro

The leaders of the world’s eight largest industrialised
nations backed Greece to remain within the single currency. With Germany
sticking to its demands for austerity though (and who can really blame them?),
it’s difficult to see how the situation can lead to anything but a Greek
default and euro-exit.

The profit-taking on sterling’s rally has taken the GBP/EUR
down to its current level of €1.2350. It is difficult to see sterling losing
too much more ground to the euro given the uncertainty that is lurking in June
but with sterling facing several risky announcements this week, we may see
today’s sideways trading theme dominate direction this week.

Against the US dollar, sterling continues to feel the heat
and is now trading down at $1.58. We expect to see the USD maintain its current
demand, though its recent rate of appreciation is clearly unsustainable.
EUR/USD has staged a minor recovery, having touched a 4-month low around
$1.2650. We are going to need to see further climb from the current level of
$1.2770 towards $1.30 if we are to revise calls for much lower levels in coming
weeks.

End
of week forecast

Sterling has climbed by a further three cents against the
euro in the past fortnight. Sterling’s progress against commodity currencies
such as the     AUD, NZD, CAD and ZAR has been ever more
impressive in the past few months. Sterling has climbed by over 10% against the
ZAR and NZD since mid-Feb, while it has advanced against the ZAR by the same
margin since mid-March.

Sterling’s safe-haven status is behind its demand and this
is not something we see disappearing any time soon. Also helping the pound was
last week’s MPC vote against further quantitative easing. Whilst there will be
some nerves surrounding the voting pattern (to be revealed by the MPC minutes
next week), stubbornly high inflation seems to be of greater concern to the
policymakers (thus making more QE harder to justify). Tomorrow’s Quarterly
Inflation Report from the Bank of England will be highly relevant in this
regard. A firmer inflation outlook is likely to be provided, which again should
be broadly supportive of the pound.

Euro suffers from lack of
Greek coalition agreement

Global
investor confidence and risk appetite has taken a turn for the worse in the
past fortnight, driven by concerns over Greece. Since the failure of the ruling
Greek coalition to maintain sufficient votes at its recent election, major
doubts have arisen as to whether Greece will remain within the euro. Coalition
talks have collapsed and another election will be held in mid-June, which means
the current uncertainty will be extended. As a result, Spanish and Italian bond
yields are on the rise, with the former’s 10-year debt yields looking
particularly alarming at fresh 2012 highs over 6.25%.

Should an anti-austerity coalition government surface from the current mess, then
Greek bailout funds would be withheld, leading to default and a probable Greek
breakaway. The knock-on effects in the eurozone and the global financial system
as a whole are expected to be more drastic than those of Lehman’s collapse. It
is no surprise then, that the euro has suffered a significant decline, with
perceived safer-currencies such as sterling and the US dollar filling the void.

GDP data
out of the eurozone was very mixed indeed this morning. Italy broadly stuck to
the script by contracting by 0.8% in Q1 of this year, while French growth
remained stagnant. However, the German economy grew by 0.5% in Q1, which helped
the eurozone economy as a whole avoid a technical recession by posting a 0.0%
GDP figure. This development has given the euro a mild boost today but with so
much austerity still to be delivered in the eurozone and today’s
forward-looking economic sentiment surveys showing a fairly sharp decline,
eurozone growth is highly likely to return to negative territory this year.

End
of week forecast

Sterling is trading at €1.25 today, which represents near
enough a three and a half year high. We are not calling a top to this pair’s ascent
just yet either, with nerves surrounding Greece likely to deteriorate over the
coming weeks. In risk averse conditions, the pound has understandably traded a
little softer against the US dollar, coming off its highs of $1.63 to trade two
and a half cents lower today. This pair could well test the $1.60 level fairly
soon, though we are not anticipating any major collapse.

Sterling has performed excellently in the past month, hitting fresh multi-month highs almost across the board. Some notably less dovish Monetary Policy Committee (MPC) minutes provided the trigger for a sterling rally in April, with the market subsequently betting against the likelihood of further Bank of England (BoE) quantitative easing (QE) – a key factor which has weighed on the pound over the past seven months.

The Office of National Statistics (ONS) last week announced the disappointing news that the UK economy contracted by 0.2% in the first three months of 2012. Taken with Q4 2011’s 0.1% contraction, this latest GDP figure signalled the UK having entered a technical recession. Nonetheless, sterling continues to enjoy strong demand as circumstances worsen on the continent.

The US dollar is still struggling to capitalise on its economy’s comparative strength. US growth data has fallen off its impressive uptrend somewhat, as shown by April’s softer unemployment figures and the recent undershoot in the first quarter US GDP figure.

This has played into the hands of the more cautious members of the US Federal Reserve, including Chairman Ben Bernanke, who refuse to rule out the possibility of another round of US quantitative easing. The market is becoming increasingly obsessed with the Fed’s monetary policy outlook and ongoing QE3 speculation continues to hurt the dollar’s performance.

The eurozone’s debt and growth situation is looking no better and worryingly, perhaps as a result of this lack of progress, the eurozone has become embroiled in fresh political uncertainty. French President Nicholas Sarkozy, could well suffer electoral defeat on the 6 May, whilst Greece will be holding parliamentary elections on the same date. Both elections could have significant ramifications on the direction of eurozone debt crisis in the short and long-term.

The Office of National Statistics (ONS) last week announced the disappointing news that the UK economy contracted by 0.2% in the first three months of 2012. Taken with Q4 2011’s 0.1% contraction, this latest GDP figure signalled the UK having entered a technical recession. Nonetheless, sterling continues to enjoy strong demand as circumstances worsen on the continent.

The US dollar is still struggling to capitalise on its economy’s comparative strength. US growth data has fallen off its impressive uptrend somewhat, as shown by April’s softer unemployment figures and the recent undershoot in the first quarter US GDP figure.

This has played into the hands of the more cautious members of the US Federal Reserve, including Chairman Ben Bernanke, who refuse to rule out the possibility of another round of US quantitative easing. The market is becoming increasingly obsessed with the Fed’s monetary policy outlook and ongoing QE3 speculation continues to hurt the dollar’s performance.

The eurozone’s debt and growth situation is looking no better and worryingly, perhaps as a result of this lack of progress, the eurozone has become embroiled in fresh political uncertainty. French President Nicholas Sarkozy, could well suffer electoral defeat on the 6 May, whilst Greece will be holding parliamentary elections on the same date. Both elections could have significant ramifications on the direction of eurozone debt crisis in the short and long-term.

UK suffers the double-dip

Whether or not the UK is indeed in a technical recession, UK growth will remain extremely weak in 2012. Disappointingly, Moody’s has recently placed doubt over the likelihood of any economic boost to the UK as a result of the London Olympics in the summer. The eurozone crisis continues to pose the greatest risk to the UK economy. As shown by the latest UK manufacturing figures, export orders are slowing and the eurozone’s economic contraction will undoubtedly drag on domestic activity.

The good news for sterling, however, is that its appeal is not based on economic growth potential. Sterling still represents a convenient alternative to investors looking to exit the euro but stay within Europe. Sterling is also a currency over which there is no threat of intervention looming (unlike the Japanese yen and the Swiss franc).

Despite the recent double-dip headlines, the UK government has reiterated its commitment to the austerity path, in order to maintain the faith of both the credit rating agencies and investors, thus keeping borrowing costs low. As a result, sterling’s ‘second tier’ safe-haven status has really come to the fore in the past few weeks and will provide plenty of support as the debt crisis rolls on.

MPC steps away from QE

Most importantly, sterling is now a currency over which there is a reduced perceived threat of quantitative easing, which contrasts particularly with the US dollar. The minutes from the MPC’s April meeting revealed that Adam Posen did not vote for additional QE, which took the market very much by surprise and left only David Miles as the solitary voter for additional monetary easing.

After a slight increase in UK inflation up to 3.5% in March, the MPC increased its medium-term inflation projections. The MPC’s apparent preoccupation with UK price pressures, over and above the state of UK growth, has seen bets on the likelihood of further QE from the BoE scaled back. With the MPC likely to remain in wait and see mode’ at its May meeting on 10 May, the pound has gone from strength to strength. Beyond this month though, there remain significant risks that the more pro-QE arguments will resurface to haunt the pound.

Downside risks to the euro

With regard to the single currency, events in the eurozone over recent weeks have certainly weighed on confidence, though not as much as one might expect. Growth data from Germany, France and the eurozone as a whole disappointed in April and another quarterly contraction is likely to be announced on 15 May. This will put the eurozone in the same boat as the UK – in technical recession. However, there’s no doubt the eurozone faces greater downside risks to growth than the UK moving forward and its recession is almost certain to continue through Q2.

Last month’s Spring IMF meeting failed to convince the markets that EU leaders have a proper handle on the EU’s ongoing crisis. The region’s ‘financial firewall’ has been bolstered by a further $430bn, which is a significant development. However, rating agency S&P has recently seen fit to downgrade eleven Spanish banks, which has seen Spanish and Italian 10-year bond yields make their way back up towards the dangerous 6.00% mark -a good bellwether of rising market tensions.

These rising tensions can largely be put down to fresh political concerns. 6 May brings the second and final round of the French presidential election. Nicholas Sarkozy is facing a likely defeat by Socialist candidate Francois Hollande, which places huge uncertainty over the EU’s Franco-German leadership, the EU’s fiscal compact and its ‘austerity first’ position.

Meanwhile in Greece, parliamentary elections threaten to prevent the country’s two leading pro-bailout parties from securing a majority, which again casts uncertainty over Greece’s bailout situation. In addition, the Dutch government’s collapse as a result of disagreements over austerity measures is telling of a growing political discontent across the region. There is a significant risk that the austerity backlash could spread to the UK local elections this week but the government is nonetheless unlikely to be derailed on its commitment to deficit-reduction.

GBP/EUR has climbed by over 2.50% in the past month, hitting fresh multi-month highs up to this week’s peak above €1.23 (the highest since July 2010). We are looking for further gains in the rate as conditions in the eurozone continue to deteriorate, with the €1.25 (80p) level representing the first key target.

GBP /USD

The US dollar remained soft in April, hemmed in by weaker US economic data and ongoing dovish rhetoric from US Federal Reserve Chairman Ben Bernanke. The monthly US jobs figure for March revealed that half as many jobs were added to the payrolls compared to February and US GDP data for the first quarter of 2012 came in at a disappointing 2.2% (annualised), against expectations of a 2.6% reading. Clearly the US economy is recovering at a far stronger pace than what we are seeing in the UK but it is the implications that this slower pace of growth (the US economy grew at a pace of 3.0% in Q4 2011) has with regard to the US Federal Reserve monetary policy.

QE3 still a possibility

The Fed was slightly brighter in its analysis of the US economy last month but is highly likely to remain in ‘wait and see mode’ for the foreseeable future. Bernanke has repeatedly put the brakes on any over-optimistic projections of US growth and has reminded the market that if the pace of US growth softens further from its current moderate pace and progress on the labour market issue stagnates, then QE3 is still very much on the table. Every time Bernanke emphasises the possibilities of QE3, the dollar sells off as risk appetite is boosted and investors chase higher yielding assets, such as the Australian dollar or stocks and shares.

The US dollar has found some favour in the past couple of sessions, helped by a stronger US manufacturing figure. However, a slide in the EUR/USD pair as a result of poor growth figures from the eurozone (Italy in particular) has proven more influential.

It has been difficult calling a top to the GBP/USD’s recent rally in the year to date. It must be said that with the recent poor UK growth figures in mind, doubts are likely to creep in with regard to the likelihood that the MPC will resist further QE this year. This may make this pair’s 8-month high of $1.63 a tough level to breach. We continue to anticipate that EUR/USD will fall through the $1.30 threshold this quarter and whilst sterling should hold up better against the dollar by comparison, a significant decline remains likely. Therefore, we are anticipating GBP/USD to ease back towards the $1.60 level, from the current rate below $1.62.

The preliminary reading of the UK’s Q1 GDP figure came in
last week to reveal a 0.2% contraction, which triggered a wave of headlines
regarding the UK economy having entered a double-dip recession. Still though,
the pound is on the offensive across the board, which is really a reflection of
its growing safe-haven demand.

There is widespread scepticism with regard to the latest GDP
figure and many, including us, are expecting an upward revision towards the end
of May. What’s more, the figure does little to change the Bank of England’s
monetary policy outlook as the MPC had already recognized the risks of Q1
contraction and appear confident that growth will pick up this year. The UK
government’s response has been to reaffirm its unwavering commitment to keep
the UK’s international borrowing costs low through ongoing austerity measures -
a popular stance with the market.

The UK’s monthly set of growth figures will roll out over
the next few days and readings of the manufacturing, construction and services
sector are expected to show a slowdown. Judging by the performance of sterling
in the past fortnight though, next Thursday’s BoE quantitative easing decision
represents the next major domestic risk event. The MPC is likely to remain in
wait and see mode next week, regardless of the UK’s economic slump in the past
three months.

US growth slows down to
strengthen Bernanke’s dovish position

The first quarter US GDP figure came in at 2.2% (annualized) last week, well below
the 2.6% reading that was anticipated. Whilst clearly outpacing the UK economy,
this slowdown is playing into the hands of the more dovish members of the US
Federal Reserve, particularly Chairman Ben Bernanke. Bernanke stated that US
monetary policy is “more or less in the right place” at the moment and interest
rate hikes aren’t expected for at least another couple of years. However,
Bernanke has once again emphasized that the door remains well and truly open to
a third round of quantitative easing and it is this factor that continues to
hurt the US dollar.

This Friday brings the monthly US non-farm payrolls figure, the most important
indicator of growth in the world’s leading economy. A weaker number is
expected, so it is unlikely that the US dollar, in the short-term, will return
to strength on the basis of domestic economic strength. However, the US dollar
will remain a safe-haven target if eurozone nerves jangle again, as they may
well do as the weekend approaches.

French and Greek elections
come into focus

Eurozone jitters are likely to increase ahead of the weekend’s final French and Greek
elections. Sarkozy’s rival Hollande is looking favourite to win the French
presidential election, while there is chance that Greece’s two major parties
(the current coalition) will fail to secure a majority. Amid this huge
political uncertainty, we may well see the euro struggle this week.

End
of week forecast

Sterling is trading up towards €1.23 this week, which is the
result of a 2.5% climb for this pair in the past month. Further gains for
GBP/EUR look probable. Sterling is trading marginally off an eight-month high
of $1.63, which is still an excellent level at which to purchase USD. There may
be room for a little more upside in the short-term but a weaker EUR/USD should
eventually drag on GBP/USD.