Euro update 2011

After a torrid time at the turn of the year the euro began to regain its equilibrium after twelfth night. The market’s change of heart was the result of an improvement in the outlook for Portugal, Spain and the other fiscally ailing peripheral states. Until January, investors had been unable to see beyond the risk of default posed by these countries. Nobody wanted to buy their government bonds. Well, not at any rate of interest that Portugal would be able to afford in the long run anyway. China was first to offer assistance, pledging to spend a portion of its huge pot of money on Portuguese and other government bonds. Later, Japan announced it would purchase a substantial part of a multi-government bond issue that Brussels would use to fund its bailout of Ireland.

The effect of the Chinese and Japanese intervention was twofold. First, it helped restore faith in the unpopular government bonds and made the need for future bailouts less urgent. Second, it implied a diversion of investment towards euro and away from America. It leaves Portugal still paying a hefty interest rate premium for its borrowings but the Lisbon government is paying less than the 7% that it described previously as intolerable. The net effect for the euro/dollar has been a protracted rally that has lifted it eight cents – more than six per cent – above its new year lows.

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.

The performance of the euro from here on in will depend on how effective the Chinese and Japanese buying is at persuading other investors to join them in buying potentially troubled euro zone government debt. For the dollar, the only real prospect of strengthening against the euro is if the Euroland government debt market suffers a relapse. That is not impossible to imagine but it is impossible to predict. As for the once-proud pound, it will have to endure weeks or months of introspection about the renewed risk of a second recessionary dip. Life will not be easy for sterling.

Those with regular euro payments to make should consider fixing an exchange rate for at least half their needs in the coming year with a monthly payment plan. The euro is not guaranteed to strengthen further against the pound and the dollar but it would be rash to bank on it weakening.