Forecasts for Pound to Euro

The Pound Sterling has many factors which are causing it to be weak on the exchange rate markets. However, in recent weeks, the prospect for the Pound has improved somewhat. These are the factors which will influence the future value of the Pound.

Factors which Influence Pound

Low Interest Rates. When UK interest rates are low, it is less attractive to hold Savings in UK banks. Therefore, there are less hot money flows into the UK. The sharp drop in UK interest rates from 5% to 0.5% has made the UK a less attractive place to hold savings so the value has gone down.

• However, the ECB are slowly realising they also need to cut interest rates very low. The ECB is more cautious about inflation, but, ECB rates are edging down towards UK rates making the Eurozone area less attractive to hold savings in. If the Eurozone experiences a prolonged recession, even the ECB may pursue a zero interest rate policy. This would strengthen the Pound relative to Euro

Finance Sector hit hard. The nature of the credit crunch has hit the UK economy hard because of our exposure to the finance sector. Also falling house prices in the UK are causing a prolonged recession.

• However, there are signs of increased weakness in the Eurozone economy. Germany has a forecast of -6% for GDP. This is because they rely on exports which are falling due to global downturn. A deeper recession in the Eurozone increases the likelyhood of low Eurozone rates and this will weaken the Euro.

Quantitative Easing. The UK has embraced quantitative easing and is effectively increasing the money supply. This increases the chance of inflation and therefore a reduction in the value of the exchange rate. The ECB (heavily influenced by the German anti-inflation sentiment) are much more reluctant to embrace an increase in the money supply. This has stregthened the Euro.

• However, the fact the UK is pursuing quantiative easing increases the chance of a quick recovery and a rise in interest rates to deal with the inflationary pressure. Therefore, this prospect of a rise in UK interest rates could increase the value of the Pound. It is likely UK rates will rise before ECB rates.

Government Borrowing. The size of UK government borrowing and the forecasts of a rise in public sector debt as a % of GDP has worried markets. There is a fear that this could be inflationary and even the UK could lose its high credit rating in the future. This would weaken the Pound against the Euro.

• However, the UK is not alone in having an increase in government borrowing. There are many European countries with a national debt which as a % of GDP is larger.

Fair Value of the Pound to Euro.

With a Pound = 1.1 Euros, items on the continent seem expensive (except alcohol, petrol and cigarettes). Places like Spain and Greece are no longer cheap for the British tourist. A fairer value may be closer to 1.2 Euros. (However, this is very subjective and purchasing power parity values often don’t influence exchange rates in short term)

The UK economy was initially hit hardest by great depression. But, the combination of quantitative easing, zero interest rates and large government borrowing means it is likely to recover sooner than the Eurozone economy which looks increasingly grim. This points to a tentative rise in the value of the Pound, unless the UK were to experience a double dip downturn.

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