Pound rockets higher, what’s driving the euro’s sell-off?

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14 February 2020

thomasdodds

The pound leapt back above the 1.30 level against the US dollar on Thursday, rallying by almost one percent versus the greenback, on the news that UK chancellor Sajid Javid had resigned from his post following Boris Johnson’s cabinet reshuffle.

T
hursday was a hectic day as far as UK politics were concerned, with the Prime Minister sacking a number of key cabinet members and high profile names, including Andrea Leadsom and Esther McVey. While Javid was offered to remain the UK’s finance minister, it was under the proviso that he would himself sack all of his advisors – something that he was unwilling to do. His resignation is a fairly extraordinary move given that the now annual budget was set to place in less than a month (11th March).

The reaction in the pound can be attributed to the fact that Javid is known to have been at odds with Boris Johnson’s spending plans, instead favouring a more conservative, tighter fiscal policy stance. The PM has already replaced Javid with Rishi Sunak – a loyalist to Johnson that is said to be in support of a more fiscally expansive approach. The implications for the UK being that the budget, whether it comes next month or at a delayed date, is now likely to entail greater government spending plans, perceived by markets as a positive for UK economic growth.

Moreover, increased spending may have the effect of lessening the immediate need for the Bank of England to tighten policy by cutting interest rates. The perceived potential boost to growth and dimming possibility of lower central bank rates has buoyed sterling in the past 24 hours, enabling it to be one of the best performing major currencies on Thursday.

Euro extends losses, falls to fresh May 2017 lows

Thursday was another very poor day for the euro, which continued on its downward spiral, extending its losses to eight out of the previous nine trading sessions. EUR/USD is now trading around the 1.085 level, over 3% lower than the beginning of December and its weakest position since May 2017.

Figure 1: EUR/USD (February ‘19 – February ‘20)

There are a number of factors at play behind the currency’s recent sharp downward trend. We outline below what we think are the main reasons for the euro’s sell-off:

  1. Coronavirus concerns – The Euro Area economy is particularly sensitive to external uncertainties to growth given that it is much more reliant on demand from abroad than its US counterpart. A potential slowdown in Chinese growth therefore presents itself as a greater downside risk to the Eurozone economy than the US.
  2. Divergence in US, EZ economic data – We have begun to see signs of a renewed divergence in economic performance between the US and the Euro Area. This has been most visible in last Friday’s strong US labour report and the Eurozone’s atrocious December Industrial production numbers.
  3. Euro acting as a funding currency – The emerging market carry trade is presenting itself as an attractive proposition for investors at present. This is a tactic in which traders long (buy) currencies with high interest rates (typically emerging markets), funded by shorting (selling) those with low interest rates, in order to profit from the interest rate differentials. With rates at zero and unlikely to be changed anytime soon in the Euro Area, the common currency is becoming increasingly popular as the funding currency for this trading tactic.

The next big test for the euro will be this morning’s GDP figures for Q4, although even a positive surprise here may not help the currency too much given the data’s time lag. This afternoon also bodes to be an important one in the US, with a number of economic data releases on tap. We will be paying closest attention to the January industrial production numbers and retail sales figures, both of which could shift EUR/USD today.