Pound to euro and pound to dollar remain trading at 1.11 and 1.22 respectively but the pound fell to a new 7 week low against the euro during yesterday’s trading as the yield that is returned on UK government debt dropped below 0 percent for the first time ever and expectation for the Bank of England to cut interest rates below zero for the first time in history increased.
On Wednesday the Debt Management Office auctioned £3.75 billion of government bonds for maturity in 2023 at an average yield of -0.003 percent. This now makes gilts very unattractive to the overseas investor given the lack of return. This is a problem for the pound as the UK currency has historically relied on the inward flow from foreign investors and without that flow, the pound will lose value. It is the Bank of England that has driven these yields lower as it has been instructed to purchase government bonds with the intention of keeping the yields as low as possible. Thus, the UK government that is currently borrowing billions of pounds to support the COVID-19 crisis can borrow at an incredibly low rate.
In March, the Bank of England announced the purchase of £200 billion of bonds although it is widely expected that the bank will increase the number of asset purchases. The bank’s quantitative easing programme now totals £645 billion and further bond buying could send sterling lower. Whilst, the impact on the pound is negative, the effect for the UK economy overall is positive.
Furthermore, markets are now of the opinion that the Bank of England (BoE) will cut its record low interest rate, currently 0.1 percent to zero or below. This will only add to the pressure on sterling. BoE Governor Andrew Bailey confirmed on Wednesday that interest rates are under active review and that he would not rule anything out at this stage. This follows on from BoE Chief Economist Andy Haldane’s, who echoed similar comments. Latest inflation figures put the UK at 0.8 percent, way below the UK’s target of 2 percent, giving the bank the ability to take this path, but if inflation starts rising, the bank will need to change tact and consider raising interest rates again.
Whilst the fall in sterling’s value is good for our exports, the UK is a net importer of goods, and as such, any fall in sterling’s value decreases people’s purchasing ability leading to a decrease in UK living standards.
Euro Gains Support as Economic Downturn Slows
Whilst the eurozone remains on track for a record contraction in Q2, the downturn in economic activity has begun to ease as lockdown measures have been lifted. HIS Markit Eurozone PMI showed an improvement on last month suggesting April’s record low was where the Eurozone likely bottomed out. However, GDP is still expected to crash to unprecedented level in Q2 and the “v-shaped” recovery that many had hoped for seems more wishful thinking than reality.
Lockdown measures across Europe have been eased but by no means has there been a return to normal. Hence, strict social distancing will remain in place and will continue to hinder any economic recovery. Capital Economics Chief Economist Andrew Wishart said that he expected eurozone GDP to fall 20 percent in Q2 and that the recovery would be sluggish.
Germany’s figures were better than France, suggesting the COVID-19 crisis has had a bigger impact on the French than German economy. This was reflected in recent Q1 GDP data which showed the French economy contracted by 5.8 percent compared with the German economy that contracted by 2.2 percent.
Pound to Dollar Remains Vulnerable on Brexit Concerns
Despite a recent increase of risk appetite from investors, which has weakened the US dollar, the pound to dollar exchange rate has failed to advance. Instead, the lack of progress in trade talks between the UK and EU has increased nervousness about the prospect of a no-deal Brexit. The UK and EU have one more round of talks, scheduled for the first week of June, before UK must confirm whether they wish to extend the transition period. However, UK Chief Brexit Negotiator David Frost has repeatedly stated that the UK will not request an extension and is prepared to walk away if the EU are not willing to compromise. Pound-to-dollar has traded lower in recent weeks as the possibility of no-deal has heightened but if no progress is made at this next round of talks, the pound could fall below 1.20 again.
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