Pound Sterling Forecast

As we see continued uncertainty in bond markets the euro is experiencing a volatile run.  In order to understand this volatility it is worth considering the basic theory behind government bonds and how the uncertainty we are seeing at present could have an adverse effect on the single currency.

I’m taking a simplistic approach here, but hopefully it will help anyone scratching their head, understand the current situation a little more. 

Bond markets are key to a countries ability to borrow money.  The government of a given country will issue bonds to investors who receive a guaranteed return on their funds.  Returns are low (in comparison to other investments) but risk is also low as historically there has been little or no chance at all of a country/government defaulting on their debt.

The credit crisis has re written the rules on government bonds.  Iceland went bust first of all, and we’ve all heard how investors (primarily our councils who had invested tax payer’s money) lost their funds.  Then earlier this year Greece almost went to the wire and had to receive emergency funding. Now there are concerns that we could see a similar situation in Ireland, in fact if the recent EU bailout had not been agreed then we may find ourselves in that situation already.

So first off we should examine the reason for this uncertainty. The banks in Ireland put all their eggs in one basket before the subprime crisis (housing crash in the US).  They lent huge amounts of money at low interest rates with very little deposit.  When these loans, (mainly mortgages) went bad and could not be repaid, the banks only had the houses that were used as guarantees to recoup losses on the loans.  Unfortunately due to the property market crash these house were worth less than the loans therefore the banks in Ireland took a huge hit.  Couple this with other high risk banking investments that went the wrong way and Irish banks found themselves in real trouble.  As a result, in the most basic terms the banks in Ireland are now running out of money.

As news has spread about the problems in Ireland companies and individuals have been withdrawing funds from Irish banks in huge numbers further damaging these banks cash flows.  Couple the banking issues with similar problems in government and we have a recipe for disaster.  The Government had spent huge amounts in the good times and already had a lot of national debt, when the recessions hit and the tax take fell, the government found the amount of money they had left to pay for their debt was not enough.  This has resulted in deep cuts in public spending and increases in the rate of income tax.  It is hoped that this will raise more money, but if the economy continues to struggle and unemployment rises you could see income from taxation fall even if taxes rise (as fewer people are earning money to be taxed on).

So to sum up the Irish economy is in real difficulty and even with the austerity measures in order to guarantee their banks can meet their debt and the government can repay theirs, the EU bailout is vital.

So bearing in mind the dire state of the Irish economy, the bond markets take on the role of a ‘confidence indicator’ through the spreads on Irish Government Bonds.  Bonds are sold to investors for guaranteed repayment after a period of time e.g.1 year 3 years 10 years.  The selling government has to pay interest on those funds that they borrow, so that the investor sees a return. Typically this will be higher for longer term bonds.  On top of the interest for the time period there will be a premium or spread for the risk factor (a risk premium).  If the country’s economy is stable and there is little or no chance of the funds not being repaid, the risk factor will be low.  However, if like Ireland the economy is fragile and investors fear they may not get their finds back they will only buy the bond if the risk premium is high.  As a result the government has to pay a huge amount of additional interest in order to borrow money.  This has a knock on effect.  Ireland has to borrow to keep the economy and banking system going.  However, it costs more to borrow, so they spend more on debt and the total amount of debt begins to spiral.  This makes it more difficult to reduce debt and please the market, which in turn increases the uncertainty about the economy and pushes up the risk factor again!

So what does this mean for your currency?

In theory if these problems continue the euro could be set to weaken further.  The EU have tried to reassure the markets but there is still a long way to go as focus is now turning to Portugal, Spain, Italy Belgium and even France.  If fears over France do persist and turn out to be true, we could see some significant euro weakness.

For the US dollar all the euro uncertainty is great news as investors in currency are flooding to the safe haven greenback which has strengthened significantly over the last month against most major currencies.

To find out more about how your particular currency requirements could be affected fill in the form on the right and one of the brokers who write on pound sterling forecast will be in touch.  You never know, it may even be me!  If you have any questions or comments please feel free to leave a message below.