Daily Insight

The Pound lost further ground against the Euro yesterday but rallied back above the $2.00 barrier versus the Dollar as a host of positive economic reports offset the criticism of the Bank of England governor, Mervyn King, as he explained the Central Bank's reaction to the Northern Rock fiasco.

The Pound received an unexpected and timely boost as UK retail sales rose 0.6 in August following a 0.7% increase the previous month and it seems that higher borrowing costs did little to dampen spending.

The pace of sales was expected to remain unchanged last month but rising house prices and a buoyant labour market are encouraging consumers to borrow and spend with the national debt ever increasing to a record £1.3 trillion.

Elsewhere, the Pound received further support as UK mortgage approvals and monetary supply were also unexpectedly strong but the statement from Mervyn King certainly hampered sentiment. In a speech the UK Treasury select committee, the governor of the Bank of England defended his handling of the Northern Rock bailout and blamed British and European Union laws for hampering the Bank's ability to prevent the worst banking crisis since 1973.

In addition, King extended an extra £10 billion in liquidity to the banking system yesterday, bringing down the three month lending rates and reversing his earlier decision to avoid helping commercial banks in need of emergency funding.

Despite the apparent lack of fundamental data released yesterday, the Euro managed to hold well above the 1.4000 level versus the Dollar and continued to make gains against the Pound as we hover just above that 1.4250 level from April 2006.

Just two years ago, the Euro was trading under 1.2000 against its U.S counterpart and the overwhelming strength of the single currency will certainly begin to slow the European economy in the months ahead.

Since the Euro-zone is so heavily dependent upon export growth, a weak currency will inevitably attract investment from overseas and thusly propel economic expansion while a strong Euro will slow it.

As a result, European economic data is likely to deteriorate in the months ahead as the 1.4000 level against the Dollar begins to have an impact on the overall economy. That may alter the ECB's monetary outlook and prevent policy makers from raising rates beyond 4.0% despite rising oil prices stoking inflationary pressures.

The Euro may struggle to make further gains today as the focus falls on the flash estimate of the Purchasing Managers' index on manufacturing and service sector growth. The report may show a modest contraction in September with manufacturing shrinking to a reading of 54.0 from the previous month, although a figure above 50 indicates expansion.

The overwhelming decline of the Dollar continued to gather momentum yesterday as the U.S currency sank to the lowest level on record against the Euro and a fresh 31-year low versus the Canadian Dollar amid speculation that the Fed will continue cutting interest rates.

The renewed weakness in the Dollar came in the aftermath of a statement from the Fed chairman, Ben Bernanke, who said yesterday that a sell-off in credit markets could intensify the housing recession.

The FOMC took the unprecedented step of cutting U.S interest rates by half a percentage point on Tuesday and may need to ease rates to 4.25% this year in order to prevent the collapse of the subprime mortgage market from the pushing the economy into recession.

Fed fund futures show a 72% chance of a further quarter-point rate cut in the October meeting, bringing the monetary policy of Europe and the U.S ever closer together. Elsewhere, Dollar sentiment was further hampered after an index of leading U.S economic indicators fell by the most in six months in August following lower consumer confidence and a rise in unemployment claims.

Data Released 21st September

EU 09:00 Current Account Balance (July)

EU 09:00 Flash PMI (September)

- Manufacturing

- Services

written by Adam Solomon