In the currency markets, it takes two to tango

For every cent that one currency gains, another weakens by the same amount; it takes two to tango when it comes to the currency markets. Last week’s sterling performance was a case in point. While UK GDP allowed for some sterling upside, the majority of the pound’s gains were seen as a result of weakness elsewhere. While commentators and pundits of various stripes continue to rail against the possibility of currency wars and competitive devaluation, the seeds of these moves were sown a long time ago.

With Greece’s issues now largely the work of behind-the-scenes committees and working groups between the Greek government and the European Union, a lot of the risks that threaten the euro have been quietly shelved. The focus therefore returns to the fundamentals of the currency and for the euro, these do not indicate an immediate run of strength. Interest rates are at -0.75% and only this month will we see the European Central Bank clarify and begin their ambitious quantitative easing plan. On a longer term basis, the divergence of monetary policies between the European Central Bank and its British counterpart will play out with a stronger pound as investors shun the euro’s lack of yield.

Pressing on fresh seven year highs at the time of writing, the obvious question has to be how much farther this run of GBPEUR strength can continue. Investors are drawn to round numbers as fat kids are to chips and the market is eyeing up 0.72 in EURGBP (1.3888) and 1.40 in GBPEUR like a particularly podgy eight year old.

The market may get its chance through this week given another expected run of strong UK data. Already we have seen the UK’s manufacturing PMI release run to the highest level since last July. While this headline number is the highest since July of last year, the component parts are telling a rather mixed story for the UK manufacturing sector. Job creation of around 5000 people a month is the obvious high point in this release, and comes hot on the heels of continuing strong output numbers and confidence that strength will remain through the remainder of the year.

The ongoing increase in demand remains focused on the consumer-side of the industry, unsurprising given the pick-up in disposable income afforded by oil price declines. This, however, is masking a rather large shortfall in longer-term investment spending which may rear its head in the future. Inflation pressures remain absent as those oil price falls continue to work through producer supply chains and into consumer baskets.

We are looking for these consumer-led gains to be carried forward into Wednesday’s services PMI number.

Where we are unlikely to see a reaction, however, is at the Bank of England this Thursday. Six years ago this Thursday, Governor Mervyn King and the Monetary Policy Committee cut the base rate to 0.5% and launched £75bn of quantitative easing. While rates have remained at that 0.5% level ever since, a further £300bn of asset purchases would be made between March 2009 and July 2012.

We are expecting the Bank of England to once again stand pat on rates this month but there is the possibility that the minutes of this meeting, due in a fortnight, will show that the Monetary Policy Committee is once again splitting. At the latest Treasury Select Committee, Dr Martin Weale was particularly hawkish on inflation and wages and could be ready to vote again for rate rises, as he did in concert with Ian McCafferty through the second half of last year.