Moneycorp Reviews The Gobal Currency Situation

According to the Bank of England's broad effective exchange rate index, the pound has not done a lot since the beginning of the year, strengthening from 79.77 to 81.45. How dull is that? Unfortunately for those who run an international business (but fortunately for those who work in the FX market and who have to remain awake for several hours at a time),  the day-to-day reality was rather more interesting than that.  At times it was far too interesting for comfort.

Between the end of last year and the beginning of July, it was the US dollar that ruled the roost and the euro that took most of the punishment. The argument in favour of the dollar was clear: America's economy was recovering more strongly, fuelled by trillions of dollars of stimulus. The argument against the euro was equally plain: Greece was on the brink of default, as a result of years of high spending and ineffective tax-collection, and the EU could come up with no coherent plan to prevent it happening. The balance of opinion on EURUSD was so one-sided that the euro retreated from $1.51 to $1.19 with scarcely a backward glance.

Sterling's decline against the dollar was less of a one-way street, but it still contrived to slide from $1.68 to $1.42, not bottoming out until a week or so after the British general election.  That election was an important milestone for the pound, both in the anticipation and the event. Inconclusive opinion polls were pointing to a defeat for Gordon Brown and Labour, but not to a Conservative majority. Investors were optimistic that Britain would end up with a new government in May, but they were uncertain as to what it would look like. Ratings agencies allowed the country to retain her AAA credit rating but warned they would readdress the matter after the election. Only after Mr Cameron and Mr Clegg had sorted out their coalition did the pound really return to an even keel. And even then, investors wanted to see what the new government's first budget would bring before they felt able to place their trust in sterling.

They liked the 'emergency' finance bill because it made a plausible commitment to bringing the budget back into balance. Ratings agencies liked it for the same reason and they confirmed that Britain would keep its triple-A credit rating. Sterling liked it because, almost at a stroke, it became a 'proper' currency once again instead of a top-shelf currency that investors would only consider buying if they thought nobody else was looking. That rediscovered respectability has allowed sterling to claw the best part of 15 US cents since the election.

The pound's recent performance against the euro has been less compelling because the euro, too, has undergone something of a rehabilitation. Its first success was the creation of a financial safety net, primarily for Greece but also in theory for any other EU nation that might find itself in a mess. The EU and the International Monetary Fund pledged a humongous pot of cash sufficient to refinance Greece's borrowings at a non-painful interest rate and to keep the country afloat. The existence of the safety net has already restored some confidence to southern European government bond markets, to the extent that even Greece itself was able to raise money with short-term treasury bills in the open market.

The EU has also had a degree of success with its bank 'stress tests'. Some 91 banks across Europe – not just in the euro zone – had to subject their balance sheets to worst-case scenarios to see if they would be able to stay in business after another recession. Critics have accused the tests of being too easy to pass. Indeed, all but seven banks did pass the tests and most of them were in Greece. The worst-case scenario for Spanish banks included a -26% fall in real estate values; that is why so many Spanish banks failed. In Greece, however, the assumption was a -2% fall and Austria's generous 'worst-case' modelled a 2.7% rise. That investors did not throw up their hands in disgust was due mainly to the fact that they had been half-expecting a whitewash. With nothing to gain by criticising the emperor's new clothes, the market decided to let it pass and held back from taking it out on the euro.

A couple of elephants remain in the parlour. From sterling's point of view, the strong 1.1% expansion of Britain's economy in the second quarter probably represents a peak. Spending cuts and tax increases are not the usual drivers of untrammelled growth. The National Institute for Economic and Social Research thinks the probability of a double-dip recession has increased from one in seven to one in five. For the euro, one successful bailout does not preclude the need for others. The safety net money is pledged, not provided. If the queue for alms were to lengthen, where would the cash come from? For the dollar, even after trillions of stimulus, the recovery seems to be running out of steam. President Obama might decide to open the taps once again, but would he be throwing good money after bad?  If only Paul The Octopus was any good at forecasting exchange rates. 

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