"Understanding Currency Market Trends: May Update"

The Pound Rides High as Stormy Clouds Gather

The pound has found some strength in the last week hitting a fresh year-to-date high against the Euro and achieving a 2-month high against the US Dollar.

The debate around the timing of interest rate cuts remains the main focus with the latest updates suggesting the European Central Bank (ECB) will be first with ECB President Lagarde recently noting that if the data reinforces the confidence that inflation will fall to 2% in the medium term then they would look to cut rates at their next meeting in June. Inflation in the Euro Area currently stands at 2.4%, very close to the ECB target of 2% and way below 7% a year earlier. Also, fresh GDP estimates for the Euro Area confirmed the economy emerged from recession in Q1 and new forecasts from the European Commission continue to point to a soft-landing scenario.

Expectations within the UK have shifted a little with a June cut now looking far less likely and August currently the odds-on favourite. This came on the back of the latest inflation figures showing that CPI has fallen to 2.3% in April, approaching the Bank of England's target of 2%, but importantly still above the markets forecast of a fall to 2.1%.

This confidence in the UK economy may well have been a significant factor in Prime Minister Rishi Sunak’s decision to call a general election in July rather than waiting into the Autumn as most had expected. However, polls still favour a change in government to one led by the Labour Party, adding political risk and uncertainty to the UK’s volatile borrowing levels in recent times. This uncertainty may begin to weigh on the pounds value as we move through the Summer and certainly something to keep a close eye on over the next 6 weeks.

We do of course then have a further election to come in the US towards the end of 2024 and again, the uncertainty this creates will likely fuel risk aversion in global markets potentially keeping the Dollar the currency of choice for the foreseeable future.

US Dollar

Over to the US and the latest minutes from the last Fed meeting noted that they continue to expect inflation to return to 2% over the medium term, although recent data had not increased their confidence in progress towards the target. As a result, the officials suggested that the disinflation process would take longer than previously thought and some suggested a willingness to tighten policy (increase rates) further should risks to inflation materialise.

This is now quite a significant shift in expectation from the start of the year when 3 to 4 rate cuts were priced in for 2024. Higher US interest rates means higher borrowing costs for financial markets globally and tends to lead to a more risk averse market and a stronger dollar, so the current relative strength in the pounds value is particularly noteworthy.

Euro – Bad news for the Eurozone’s biggest economy

A recent report by the International Monetary Fund (IMF) offers a bleak outlook for Germany's economic future. The analysis highlights a looming risk of stagnation over the medium term, driven by the mass retirement of baby boomers. This demographic shift is expected to strain public finances significantly while concurrently reducing tax revenues.

Compounding the issue, fewer people are projected to enter the workforce. Germany's birthrates have been consistently lower than during the baby boom era, and immigration has also been curtailed. As a result, the IMF forecasts that annual growth could plummet to 0.7%, drawing comparisons to Japan's prolonged stagnation since the 1990s, characterized by unresolved challenges related to an aging population.

Germany's economic predicament is not unique; other countries, including the UK, face similar issues. However, Germany has a potential strategy to mitigate these effects: loosening its "debt brake," a policy that restricts borrowing. By relaxing these constraints, Germany could increase borrowing to invest in long-term infrastructure projects, net-zero transitions, and other initiatives that could yield sustained economic benefits.

Another suggested measure is indexing retirement ages to life expectancy increases, a step already taken by the UK and, more recently, by France, which raised the retirement age from 62 to 64. Conversely, the report advises against substantial tax breaks for pensioners, as proposed by UK Prime Minister Rishi Sunak with the triple lock plus, which could further strain public finances without addressing underlying economic challenges.

Overall, the IMF's report underscores the need for proactive and strategic policy responses to navigate the economic headwinds Germany faces in the coming years.

South African Rand

South Africa is in the midst of a pivotal election, touted as the most consequential since the end of apartheid. Early polling indicates a significant shift, with the African National Congress (ANC) seemingly poised to lose power for the first time since Nelson Mandela's historic victory thirty years ago.

Discontent is palpable across the nation, fuelled by rampant unemployment, stark inequality, persistent water shortages, and frequent power outages. Unlike the previous generations who felt a deep loyalty to the ANC for its role in ending apartheid, today’s younger voters are more critical and less inclined to support the party unconditionally.

If the ANC secures less than 50% of the vote, South Africa may witness the formation of a coalition government. In this scenario, the ANC could retain power but would need to rely on alliances with smaller parties. Conversely, if the largest opposition party, the Democratic Alliance (DA), performs exceptionally well, it might be able to form a coalition with various smaller parties, potentially leading to a significant political realignment.

Financial markets are closely watching the election, particularly the performance of the South African Rand (ZAR). Analysts expect the ZAR to experience volatility as investors react to the unfolding political landscape. A weakened ANC majority or the formation of a new coalition government could initially unsettle the markets, leading to fluctuations in the currency's value. However, a stable and effective coalition could eventually restore investor confidence and stabilize the ZAR in the long term. The outcome of this election is crucial not only for South Africa's political future but also for its economic stability and the strength of its currency.