February was the ultimate game of two halves for sterling. Contrary to our prediction here a month ago its performance was almost an exact replica of January’s boom and bust. The pound strengthened almost to €1.20 before turning tail to retrace its steps even more quickly than it had moved forward. The whole scenario was directed not by the relative economic performance of the UK and Euroland economies but almost entirely by investors’ hopes for interest rates.
It was sterling that set the interest rate ball rolling. Despite a dreadful economic performance in the last three months of 2010, during which the UK economy shrank instead of growing, investors began to focus on inflation. Underlying that attention was the thought that the Bank of England’s Monetary Policy Committee simply couldn’t just sit on its hands while inflation roared ahead. It would surely realise that to do nothing about it would be to prejudice its credibility. Never mind that a good half of the inflation rate was down to just two factors, January’s VAT increase and the international price of oil, neither of which would feel any effect from the level of interest rates: the MPC would eventually have to be seen to be doing something.
When January’s inflation figure came in at 4.0% it encouraged that belief. Thereafter a series of speeches, comments and pronouncements from various Bank of England and MPC worthies gave the idea legs. MPC member Andrew Sentance was most vocal on the subject. For several months he had been calling for a rate increase and his calls became louder and more frequent. At the January MPC meeting he had been joined by new boy Martin Weale in voting for a rate increase and their argument found support – albeit reluctant support – among the UK media. When the minutes of the February meeting came out they revealed that a third member had joined them, Bank chief economist Spencer Dale. Upping the ante, Mr Sentance had voted for an immediate half percentage point rise while his co-conspirators would have been happy with a 25 basis point increase.
Meanwhile in Frankfurt, the chaps at the European Central Bank had been reviewing their stance. Developments in North Africa and the Middle East were changing the big picture. In particular, the slow-motion revolution in Libya was threatening oil production and pushing up oil process even more quickly than they had already been rising. The ECB had been relatively comfortable with an inflation rate of 2.4%, above target but only by 0.4 percentage points. Now it saw oil prices taking that rate higher. The ECB is much less relaxed about the idea of ignoring “external” inflationary pressures, especially if they might threaten to slip the anchor of consumer expectations.
In an apparently coordinated series of similar statements two members of the ECB executive committee and one governing council member said the Bank would not hesitate to act if inflation looked likely to become a problem. None of them went so far as to promise a rate increase but together they constituted – at least as the market was concerned – a clear hint that something was afoot on the inflation front.
Once that idea caught the imagination of investors they switched their allegiance from the pound to the euro. It did not help that, with the minutes of the February MPC meeting, sterling had fired its last remaining interest rate bullet. All the talk had been talked and every expectation had been met. There was nothing else to play for until the next MPC meeting and the market was not holding its breath for a rate increase on 10 March. To compound sterling’s felony, the first revision to UK economic growth in the fourth quarter of 2010 brought a downward revision of the shrinkage from -0.5% to -0.6%.
At the moment the force is with the euro, not the pound. That force could increase when the ECB holds its next monetary policy meeting. Although it does not look likely at this stage that there will be an increase in the 1.0% refinancing rate there are other tightening adjustments it could make, such as less generous funding facilities for Euroland’s commercial banks. That is not to say it is game over for sterling. The spectre of a bankrupt Portugal still lurks in the wings. Plenty of the smart money says a Greco-Irish style bailout will happen in the next few weeks. Investors are changing their opinion with their socks and the situation in three or four weeks’ time is unlikely to be the same as today’s. Look for continued uncertainty and yet more changes of direction.