Sterling / Euro
The pound recovered some of the losses of the last few days as the threat of the UK losing its AAA credit rating receded following the emergency budget.
The six week old government announced a series of measures including the imposition of a levy on banks and raised VAT in the biggest budget-deficit cuts in a generation, seeking to guard the top credit rating without stifling economic recovery.
Lowering forecasts for growth to 1.2% this year and 2.3% in 2011, Chancellor of the Exchequer George Osborne announced a freeze on public workers’ pay and child benefit along with a reduction in housing benefits. Capital gains taxes were raised and corporate-profit taxes cut.
“This is the unavoidable budget,” Osborne told Parliament, delivering the package six weeks after taking over. “Everyone will be asked to contribute.”
Tackling the largest fiscal shortfall in the Group of 20 nations may test the durability of the Conservative-Liberal Democrat coalition and the strength of union opposition. It also leaves the UK at odds with President Barack Obama’s stimulus drive on the eve of the G20 meeting in Toronto.
Osborne, 39, the youngest chancellor since 1886, is aiming to cancel a deficit that reached 11% of GDP in the last fiscal year. Fitch Ratings warned on June 8 the U.K. may lose its AAA rating if it fails to speed cuts. It has since commented that yesterday’s budget was “a good start”.
The pound and gilts rose as Osborne announced the plan would eliminate the structural deficit by 2015, with net debt peaking at 70% of GDP by 2014. He rejected suggestions the government needed to choose between growth and fiscal order as a “false choice.”
Overall, he said spending would be cut by 30 billion pounds a year, including 11 billion pounds from welfare, while the increase in value-added tax to 20% in January from 17.5% would yield 13 billion pounds a year by the end of the Parliament in 2015.
The levy on banks would tax their balance sheets starting next year, generating 2 billion pounds of revenue. The tax will be set at 0.04% in 2011, before increasing to 0.07%. The levy will apply to British banks as well as the subsidiaries and branches of overseas banks. Firms will only be liable for the levy when their relevant aggregate liabilities exceed 20 billion pounds, the Treasury said on its website.
Pledging to bolster investment and employment, the government put the corporate tax on a slide to fall 4% to 24% over four years and raised the threshold at which employers start paying national insurance.
To blunt the impact of the cuts and convince voters that ordinary Britons won’t suffer unduly, Osborne raised the ceiling at which the lowest rate of income tax is levied by 1,000 pounds to 7,475 pounds, exempting 880,000 low earners from payment. He also maintained spending on schools, hospital buildings and other infrastructure projects. The basic state pension will now be linked to earnings rather than prices, he said.
“Unemployment will peak at 8.1% this year before falling to 6.1% in 2015″ Osborne said.
In increasing the tax cap, Osborne adopted a policy of the Liberal Democrats, junior partner in a coalition with Osborne’s Conservatives. The increase in VAT may still lead some Liberal Democrats to rebel as unions call for an emergency meeting to develop a strategy to fight.
Policy makers say a Greek-style bondholder revolt is a bigger risk to the economy than a return to recession and that restoring order to the public balances will ultimately boost the economy. Bank of England Governor Mervyn King last week backed retrenchment and said “monetary policy could respond if the prospects for growth subsequently deteriorated”.
“Some have suggested that there is a choice between dealing with our debts and going for growth,” Osborne said. “The crisis in the euro-zone shows that unless we deal with our debts there will be no growth.”
The argument over how soon to withdraw stimulus as the global recovery gains momentum will play out on the world stage when G-20 leaders convene in Toronto on June 26-27.
Obama said in a June 16 letter to his counterparts that they must avoid the “mistakes of the past” when economic support was withdrawn prematurely, while German Chancellor Angela Merkel says “there is no alternative” to cutting deficits. Japanese Prime Minister Naoto Kan’s government today vowed to cap annual spending for the next three years and balance its books in a decade.
“The U.K. is a test case,” said Tim Adams, a former U.S. Treasury undersecretary and now managing director of the Lindsey Group, a Fairfax, Virginia-based investment consulting company. “If Osborne’s budget works that will have a profound impact on the debate in the U.S.”
Meanwhile, Fitch, the ratings agency said that although the risk of a euro zone break-up was low over the short to medium term, further episodes of “extreme market volatility” were likely to persist until the recovery and deficit reduction were secured in the region.
A report by Fitch said the crisis in the euro zone and investor concerns over the sustainability of the region had arisen because of the existence of the following:
- Economic imbalances.
- Scepticism over the ability of economies within the euro zone to adjust in the absence of monetary and exchange rate flexibility.
- Concerns about fiscal solvency given large fiscal deficits and weak economic growth prospects.
- Doubts over the political commitment to the euro zone in the aftermath of the hesitant and reluctant support given to Greece.
The report came as Juergen Stark, executive member of the ECB, said that markets and ratings agencies had behaved irresponsibly in response to the debt problems faced by Greece.
“What we have seen, how markets have reacted on Greece, on other countries, and in particular rating agencies, this was done in an irresponsible way, an irresponsible way in the case of Greece,” he said at a Centre for European Reform event in London.
“In the middle of negotiations [with the International Monetary Fund], rating agencies downgraded Greece. Markets have exaggerated the problems,” he added.
Mr. Stark argued that the euro zone’s monetary policy framework did not need to change because of the sovereign debt crisis.
“What we are witnessing now is not a crisis of the euro, what we are witnessing is a loss of public confidence by markets in the ability of governments to run sound and responsible fiscal policies,” he said.
“Where I do not see any need for an adjustment or change is the monetary policy framework we are in. We need to step up fiscal consolidation and implement structural reforms. Secondly, we have to strengthen the fiscal rules. And thirdly, the economic policy co-ordination has to be enhanced, and the surveillance as well.”
Mr. Stark said he did not believe that enthusiasm for euro membership was waning among the German public. Germany was perceived to be reluctant when it came to committing to a €500bn (£417bn) fund facility for troubled countries in the region.
“They, the Germans, have [seen] that the euro is a stable and credible currency, and they appreciate that the ECB has delivered over the past 10 years,” Mr. Stark said.
The Euro zone was further undermined when the rating’s agency Moody’s downgraded the credit rating of one of France’s top banks, BNP Paribas.
Ahead of the publication this morning of the minutes of this month’s Bank of England Monetary Policy committee meeting, the pound continues to regain the losses of the last week to edge up towards the 20 month highs seen earlier this month. If, however, the minutes show that the MPC’s Quantitative Easing (QE) program is not over, this could once again undermine the pound.
Sterling / US Dollar
The pound also made inroads against the dollar following the release of poorer than expected housing data yesterday afternoon from the US.
Sales of previously owned homes fell unexpectedly in the US in May as delays in processing mortgage applications hampered the closing of contracts benefiting from a popular homebuyer tax credit, an industry group said on Tuesday.
The National Association of Realtors said sales fell 2.2% month over month to an annual rate of 5.66 million units from an upwardly revised 5.79 million-unit pace in April.
Analysts polled by Reuters expected May sales to rise 5.5% to a 6.12 million-unit pace from the previously reported 5.77 million units in April.
Sales were up 19.2% compared to May last year.
Sales had been expected to rise as transactions for existing homes are measured at contract closing. Although the tax credit for home buyers expired in April, qualified home owners have until June 30 to close contracts.
“There hasn’t been much of a rebound in housing. We are growing from the extremely low levels of last year. On average, we are looking for a moderate advancing trend,” said Stephen Stanley, chief Economist at Pierpont Securities in Stamford, Connecticut.
U.S. stock indexes pared gains on the report, Treasury debt prices rose.
The dollar was up slightly against the euro but fell to a session low against the pound.
The return to risk appetite following the Chinese action over the weekend to liberalize the Yuan against the US dollar appears to be short lived. The poor US data and persistent worries about the Euro zone have undermined confidence once again.
Falls were registered in virtually every stock market yesterday including London, Frankfurt, New York, Tokyo and Shanghai and oil prices also fell.
Tonight’s Federal Reserve Rate meeting is expected to be a ‘non event’ in light of the mixed data coming out of the US of late.
GBP/High Yielding Currencies
The pound recovered against the high yielding currencies yesterday as a combination of the UK emergency budget and China pulling back the veil on its new currency regime a little further on Tuesday, appearing to engineer a fall in the Yuan to make clear its vow of flexibility did not include one-way bets for appreciation helped the pound retrace against the Australian Dollar, New Zealand Dollar and South African Rand.
Big Chinese state-owned banks kept the Yuan in check, a day after its biggest rise since the currency was revalued in 2005, and the Foreign Ministry said change would be gradual, indicating the Yuan’s appreciation will be far slower than the pace demanded by critics in the West.
China has started to relax its control over the Yuan ahead of this weekend’s G20 summit of world leaders in Canada, breaking a two-year dollar peg that had been a lightning rod for critics who say the currency is undervalued and gives Chinese exporters an unfair trade advantage.
“China has backed up all the talk with action, and President Hu (Jintao) will arrive in Toronto later this week with tangible evidence that China is serious about increasing the flexibility of its exchange rate,” said Brian Jackson, strategist with Royal Bank of Canada in Hong Kong.
“We still may see moves in either direction from day to day, but we think the trend in the weeks and months ahead will be for the Yuan to make limited but meaningful gains against the dollar.”
Under its new freedom, the Yuan rose on Monday more than 0.4 percent, the biggest rise in a day since its landmark revaluation in 2005. It also came close to hitting its trading limit of 0.5 percent, an amount the currency can move either side of a reference point set each morning by the central bank.
On Tuesday, the Yuan fell just over 0.2 percent.
The fall disappointed many market players, who had initially thought the central bank’s decision to set the reference rate in line with Monday’s close was a sign that it was willing to let the currency strengthen further.
State-owned banks stepped in to the market by mid-morning and aggressively bought dollars, traders said, suggesting authorities want to control the pace of the Yuan’s appreciation.
Data Released 23rd June
GER 07:00 – GFK Consumer Confidence (July)
EU 9:00 – Flash PMI (June)
U.K 09:30 – BoE Minutes
Uk 11:00 – Distributive Trades Survey (June)
CZK 12:00 – Rate Announcement
NOR 13:00 – Rate announcement
US 15:00 – New Home Sales
US 19:15 – Rate announcement
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