Foreign Currency Report 01 September 2008

Sterling  

The British Pound exchange rate hit a two year low against the US Dollar for a short period on Friday, after stronger than expected readings of U.S. business activity compared with a recent set of figures showing ongoing weakness in the UK economy. Sterling slipped to its low according to Reuter’s data after the U.S. Institute for Supply Management Chicago business barometer posted a surprising surge to 57.9 in August; it’s highest since June 2007.  

This compared with disappointing figures on UK housing and retail sales, as well as a flat reading of economic growth earlier this week, has added fuel to the argument that the UK economy is suffering and could require a cut in interest rates in the coming months. If this is to materialise then don’t be surprised to see the Euro and Dollar currencies make further gains in the coming months.  

US Dollar  

The Dollar posted its biggest monthly advance against the Euro since the European currency's 1999 debut on evidence economic weakness that began in the U.S. has spread and also as crude oil prices have declined. The greenback increased against all of the other major currencies in August, climbing for a fifth straight month versus the Yen and as noted earlier in this report most evidently against the Pound which depreciated to its lowest level since 1992. The situation in the rest of the world is perhaps deteriorating much faster than the market was first expecting which is pushing the Dollar higher. In fact federal funds futures on the Chicago Board of Trade show a 19 percent chance that the Federal Reserve will increase its 2 percent benchmark by at least a quarter-percentage point by its Dec.16 meeting.   

Policy makers agreed in August that their next change in interest rates will be to raise them, while reaching no definite timelines for when this will happen, according to minutes of their Aug. 5 meeting released last week. Federal Reserve policy makers next meet on Sept. 16.   

Euro  

Europe’s gross domestic product (GDP) shrank 0.2 percent in the second quarter, the first contraction since the 15-nation common currency was introduced in 1999. Annual inflation eased to 3.8 percent in August, from 4 percent the prior month. The ECB tries to keep inflation just below 2 percent. ``There's clearly a downward trend for growth and inflation,'' said Benedikt Germanier a currency strategist at UBS AG in Stamford, Connecticut. ``That argues for the euro to stay under pressure.''   

Traders have now stepped up bets that the European Central Bank will reduce borrowing costs, although when this will happen it is unclear, with the likelihood being that it will be well into next year. The ECB will likely hold its main refinancing rate at a seven-year high of 4.25 percent at its meeting this Thursday, according to a consensus of analysts.  

Anybody who has been looking at the currency markets without having their eyes closed over the course of the last year will know that we are and have been for some time in a credit crisis. The massive Fed and ECB lending has not really eased this situation, so what happens next?The credit crisis first started back in 2007 and is now around a year old, there has been a debate during this time about whether the financial system will recover, or will the Western/world financial system end up like the Japanese financial system after the stock and real estate crashes in the 1990's. In that case, the Japanese banks more or less carried their losses for a decade as Japan entered a mild but painful period of deflation. To this day, Japan is still suffering some of the deflationary forces of that time. The question now becomes, will the Western financial system recover or are things going to get worse and the world end up with a financial problem lasting ten years like Japan's?   

The ECB and the Fed are both hoping to find a way out of having to keep the bad assets they took as collateral. They have lent hugely to financial institutions, taking their bad mortgage bonds, securities and derivatives as collateral. At the same time, the financial institutions in question are carrying a sum total of $500 billion of losses on their books, (and that’s only the losses they have admitted so far!), while estimates of ongoing losses from these bad assets runs well over $1 trillion.   

In effect, the Western credit industry is still crippled so it is more than likely that we will see further credit issues for all the major currencies. Perhaps the most worrying thing for all those buying currencies based with Sterling is that whilst this Credit Crisis continues Sterling is being effected the most. In my opinion it will not be long before we see Interbank exchange rate levels for the Euro below the 1.20 mark and the US Dollar back down into levels in the 1.70’s  

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