Foreign Exchange Rate Forecasts: Exchange rates fall after BoE Inflation report

Good afternoon. In my last post I outlined the fact that Sterling had made a recovery against the Euro. However I’m afraid the recovery was short lived, and the Pound has continued to lose value and rates have fallen. In today’s post I’m going to explain why this has happened, and look at the Pound/Euro trend for the coming months.

So let's get straight on to why rates have fallen again...

This morning at 10:30am, the Bank of England (BoE) released it’s latest inflation report, delivered by outgoing governor Mervyn King. A link to the full report is here. This afternoon I will simply run over the effects on exchange rates rather than analyse the full report in detail.

Recent figures have shown that the economy shrank by 0.3% in the last three months of 2012, fuelling fears that the UK could re-enter recession, defined as two consecutive quarters of contraction. In todays report, Sir Mervyn said: ‘The UK economy is set for a recovery. That is not to say that the road ahead will be smooth. This hasn't been a normal recession and it won't be a normal recovery.’

A more recent GDP estimate indicates that there may not be a contraction in the first 3 months of this year. Indeed, the BoE does not expect a triple-dip recession but said GDP was likely to continue at below pre-financial crisis levels for around another two years.

"Growth is likely to be weak in the near term but further out a continued easing in domestic credit conditions, supported by the Bank's asset purchase programme and the Funding for Lending Scheme, together with the stronger global backdrop, underpin a slow but steady recovery in output," the governor said.

The key to why the Pound fell is that the markets see his comments as Sterling negative. Sir Mervyn King said “there are limits to what can be achieved via general monetary stimulus” as he urged the Government to “find ways of boosting overseas demand for our products” and push through “supply reforms” – often associated with tax cuts and deregulation.

Reading between the lines, what he means by this is we need a weaker Pound in order to make our exports more attractive. There is now the increased chance of further Quantitative Easing. The BoE actually want the Pound to weaken further and their policy moving forwards will likely reflect this. That is the reason the Pound fell so sharply when the report was delivered.

Also of concern is the fact that the Bank’s update on the state of the economy came as the head of the Government’s Debt Management Office claimed that markets expect the UK to lose its prized AAA sovereign credit rating – this is also weighing on the Pound and knocking exchange rates lower.

Sir Mervyn was delivering his penultimate Inflation Report. His last Report will be in May, before he is replaced by Mark Carney as governor in the summer. It will be interesting to see if Mr Carney also pursues the policy of trying to weaken the Pound to encourage an export led recovery. We shall see. There are some interesting charts on the telegraph website which you may find of interest here.

Nobody can predict which way the markets will move. My personal view is that we could well see more weakness, especially if we do lose our AAA credit rating and/or see more Quantitative Easing from the BoE. So for those needing to buy Euros, you should consider your options now to protect against adverse exchange rate movements.

Rates for those converting back to Sterling are close to an 18 month high, so if I needed to convert Euros back to Sterling I would be keen to take advantage of the rate while it is favourable.

In the EU, there is talk of the European Central Bank also trying to weaken the Euro in the same way as our central bank is weakening the Pound. This could cause rates to climb back but there is no way of knowing if this will happen. We are entering the dangerous arena now of a currency war, where central banks race to try and devalue their currencies to make investment into their country more attractive. This makes predicting where exchange rates may move impossible and also makes swings in the rate extremely volatile, such as we have seen over the last few weeks.

As you can read here, G7 nations have recently agreed not to engage in so called currency wars, however what is said and what actually happens are often very different things.

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