ECB rate changes will lead to weaker sterling
Most commentators believed that the bank would raise rates in February, coinciding with the release of the quarterly inflation report. However, the MPC decided to surprise the markets with an earlier than anticipated move.
The second and lesser surprise was the wording of the European Central Bank’s press statement which accompanied the decision to leave official interest rates unchanged at 3.5%. This decision had been widely anticipated but there was a growing feeling that the ECB would signal another rate hike for February.
However, the wording of the statement in which the ECB president said the bank would monitor developments very closely rather than ‘vigilantly’, suggest that the next move may not occur until March.
The impact of these two events was to strengthen sterling versus the euro.
The latter was already under pressure against the dollar as recent US economic data pointed to a growing delay in expected cuts in official US interest rates. This euro weakness versus the dollar made the euro all the more vulnerable versus sterling, following the Bank of England’s surprise move on interest rates.
The British decision to act earlier than expected was more than likely caused by the risk that the annual rise in the consumer price index for December could exceed 3%, up from 2.7%.
Largely as a result of these shifting interest rate decisions, sterling has risen to its highest level against the euro since mid-2004. At the same time, the dollar has strengthened to below $1.30 versus the euro.
What are we to make of these currency moves? Firstly, it would be a mistake to believe that currency movements can be forecast on the basis of a single factor, such as interest rate differentials, even if they are a popular explanation at the moment.
Secondly, as markets tend to look out over very short term horizons, the current trends could continue for a while. This means that sterling could rise towards £0.65 and the dollar to $1.28 versus the euro.
Looking beyond the near term, however, both sterling and the dollar are likely to weaken versus the euro. The downturn in the US economy is expected to be sustained over much of 2007, leading to a weakening of the jobs market and a rise in unemployment. The outlook for inflation is also improving in the US which should permit the Fed to relax monetary policy.
It is increasingly possible the Bank of England will hike official rates again in the first half of the year. However, inflation should ease quickly in the months ahead and the economy, though sound, could weaken by mid-year.
The ECB still regards official rates as low and policy as accommodative. The economy is growing solidly above its non-inflationary growth potential. On this basis, eurozone interest rates are expected to rise to 4% or more in 2007.
Higher eurozone interest rates and a stronger euro economy should lead to a reversal in the current strengthening of sterling.
At this stage, the markets have priced in another British interest rate hike of 0.25% but have not yet factored in just how far the ECB could go this year. Sterling sellers, therefore, should keep a close eye on this current opportunity.
John Beggs chief economist AIB Global Treasury
