A highly volatile day saw the pound benefit strongly from the bearish tone of the markets worried about the prospects of Italy and Spain following Greece, Portugal and Ireland into bailout territory amidst worries that the US economy has stalled and the prospects for the world economy take a turn for the worse.
As a result, the pound reached a 2 month high against the euro, Australian and Canadian dollars but fell heavily against the US dollar and Swiss Franc, the two principle safe haven currencies.
Yesterday, there were no surprises from the Bank of England as its Monetary Policy Committee (MPC) opted to keep interest rates at the record low 0.5% level for at least another month and the quantitative easing (QE) programme unaltered at £200 billion.
Speculation that the MPC would look to tighten monetary policy this year has largely given way to a belief that recent signs of economic weakness mean that further loosening, through an expansion of quantitative easing, is a more likely option.
Dr Howard Archer, UK economist IHS Global Insight, said the current softness of the economy and heightened concerns over both the domestic and the global economic outlook meant that unchanged interest rates of 0.50% were a “stone dead certainty” despite elevated inflation.
To add to the miserable outlook, the National Institute of Economic and Social Research (NIESR) predicted yesterday that the UK economy will grow by only 1.3% this year and by 2% in 2012. It said the coalition government should ease off its deficit-cutting agenda to improve the outlook for economic growth and employment in Britain.
Similarly, the European Central Bank (ECB) kept its benchmark interest rate unchanged at 1.5% but caused a stir in the markets when Jean Claude Trichet, President of the ECB told a press conference that the ECB would start buying up sovereign bonds again.
On the subject of inflation, Trichet said the risks remained “on the upside,” despite overall price rises slipping to 2.5% in July from 2.7% in June.
Italian President, Silvio Berlusconi, has mounted a desperate rear-guard action to reassure the markets, claiming his country has “solid economic fundamentals” and Italian banks are well capitalised.
He told the Italian Parliament that the country’s banks are “solid and solvent” and that there is a “crisis of faith in the international markets”. Italy is about to introduce a €43 billion austerity package but there are doubts regarding whether the government will see it through.
Yields on Italian 10-year bonds hit their highest levels since the launch of the euro on Tuesday of 6.09%.
Spanish bond prices faced a similar onslaught, with yields hitting 6.25% on Wednesday afternoon.
Jose Manuel Barroso, President of the European Commission, has said the bond markets’ treatment of Italy and Spain is “a cause of deep concern”.
Sanjay Joshi, head of fixed income at London and Capital, said Italy, Europe’s third largest economy, was at a critical phase.
“If Italian yields continue to rise to 7% and they become totally unsustainable that really raises a question mark over the whole euro project,” he said.
Analysts told Reuters that Italy might not be able to survive high interest rates for as long as Spain because, at almost 120% of GDP, Italy’s debt burden was almost double that of Spain.
“The endgame is whether Germany wants the euro to survive in this current format or do they want it to change?” said Joshi.
“Do they want to retain all the members that it currently has or do they want some of them to disappear and constitute a new euro which is based on the heart of Europe?”
Commentary by Tony Redondo
“Any opinions expressed in this document are those of TorFX analysts. Any analysis and/or forecasts provided are aimed at helping clients understand market conditions and developing trends. Clients are wholly responsible for their own trading decisions.”
