Monday, March 15, 2010

Forecasts for Pound to Euro in 2010

2010 has been a dismal year for Pound Sterling so far. It has fallen against the dollar to just above $1.5 to £1. It has fallen against the Euro to Euros 1.1. Many commentators are betting on the Pound falling to parity against the Euro.

The weakness of the Pound is primarily caused by the combination of
  • Record Budget Deficit (close to 12% of GDP)
  • Political uncertainties over general election and any concrete plan to tackle the deficit in the medium term.
Investors fear that in the absence of a medium term plan to tackle the budget deficit, there is the prospect of a rating downgrade, and higher interest payments on UK debt. There is also the fear that continued government borrowing could lead to inflation in UK. This would reduce the value of Sterling further.

The continued trade deficit (January's figures showed biggest deficit since Aug 2008) suggests the Pound was overvalued for a long time. And it is taking a long time for fall in the pound to help correct the underlying deficit. As we mentioned recently, the devaluation in the Pound, has so far, taken quite a long time to have the effect of reducing the deficit.

With the bailout for Greece agreed, the Euro has strengthened. So far, the EU seem to be pursuing a strategy of debt reduction and tighter fiscal rules. This will be good for the value of the Euro (though recovery in the Eurozone economy may be a different matter)

Outlook for rest of 2010 / 2011

The UK recovery is still fragile, house prices are in danger of a double dip fall, unemployment still threatens to continue rising. This will make it difficult to cut the deficit in short term. It also means interest rates may stay at 0% for the rest of the year.

Investors seem very concerned about the prospect of a hung parliament - which last occurred in the 1970s with unhappy memories. However, all main parties do talk about reducing the deficit in the medium term. - even if they are reluctant to talk of specifics before an election. There is no reason to think even a hung parliament has to lead to paralysis in deficit reduction.

If there is a moderate economic recovery, then spending cuts and tax increases can be absorbed without hindering recovery. Once markets are convinced that borrowing is 'back on track' the pound's battering should end. The problem is that it is very much a grey area what exactly is sustainable borrowing levels.

UK National Debt as a % of GDP, is certainly high, but not devastating. It is higher in many other countries. Whatever jittery markets may fear, there is hardly signs of a sovereign debt default in the UK.

I cannot see the ECB changing its strategy of maintaining low inflation and deficit reduction as primary goal. But, it will leave the Euro economy weak. Apart from Germany, many Eurozone economies are struggling with the relative strength of the Euro.

The Weak Pound is unfortunate for tourists travelling abroad. But, it is at least helping to minimise this prolonged downturn.

Outlook, the Pound may continue to be weak, falling even to parity by May. But, the Pound should become stronger after the uncertainty of the election.

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