Euro update 2011

It was another zero-sum game for sterling in February. A three-cent rally in the first half of the month gave way to a three-cent retreat that left the pound unchanged in late February from its position at the beginning of the month. Almost the whole exercise was driven by interest rates. Not actual changes in interest rates but in the market’s expectations of where they might go. The revolutions in North Africa and the Middle East made an unwelcome contribution to the proceedings.

Initially everything revolved around the prospect of a sterling interest rate increase. Investors fancied that the Bank of England could not stand idly by with UK inflation running at double its 2% target level. The Monetary Policy Committee must surely act to increase the Bank Rate? Mustn’t it?

From sterling’s point of view the game changed dramatically in late January with the publication of figures for UK gross domestic product (GDP). After growth of 0.3%, 1.1% and 0.7% in the first three quarters of 2010 the expectation was that the economy would have expanded by 0.4% in the fourth quarter. Investors were therefore shocked when instead of achieving modest growth the UK economy turned out to have shrunk by -0.5%. Sterling took a tumble from which it could take months to recover.

That argument kept sterling aloft until the European Central Bank made its presence felt. Three of its top people, on successive days, made the unnecessary comment that the ECB would increase euro interest rates if inflation were to become a problem. On the face of it the statements had no news value: everyone knows that is what the ECB does. So they must have been hinting at something. The ECB is worried that soaring oil prices will push Euroland inflation (2.4% at the last take) beyond the comfort point. Such a development would be anathema to the ECB so it is going to raise interest rates sooner than previously expected. That, anyway, was how investors saw the situation.

So sterling went up and then it went down. There could be more of that in coming weeks as Portugal follows Greece and Ireland down the road to receivership or the Bank of England surprises everyone with a March rate increase. Rely on uncertainty and hedge half of your euro exposure at a fixed price.