June 2011 Interest and Exchange Rate Forecast

The June 2011 RBS Interest & Exchange Rate Forecast (PDF) is out.

Interest Rates

The Bank of England did not raise rates in June, despite higher inflation due mostly to commodity prices. In order to curb inflation, their Monetary Policy Committee (MPC) may raise interest rates, but it depends on the strength of demand in the United Kingdom.

In the US, as quantitative easing (QE2) draws to an end, the Federal Reserve is turning to how and when it starts to tighten policy. The April minutes of the Federal Open Market Committee meeting indicate that it has a preference to lead with interest rate hikes, which would curb inflation, rather than begin unwinding its quantitative easing program (though options for this were discussed). RBS expects the Fed to wait until the first half of 2012 before raising interest rates.

The European Central Bank (ECB) left rates on hold at 1.25% in June, but by using the code word “strong vigilance” President Trichet signalled a second hike for the year at the next ECB meeting in July. With inflation at 2.7% in May and above the 2% ECB target for six consecutive months, the ECB Governing Council will justify an increase in interest rates despite signs of a slowdown in the euro area. ECB President Trichet suggested the establishment of an EU Ministry of Finance with veto rights over member states’ specific spending decisions as a first step towards closer fiscal union. While this will be of little help in the fight against the current sovereign debt crisis, it may be an issue to be tackled by Mario Draghi (Italy) in October, who has received the support of France, Germany and the ECB to succeed Trichet as President.

Exchange Rates

The euro plummeted from 1.49 against the USD to 1.40 in mid-May – a two month low, while GBP/EUR jumped to 1.15. But much of the lost ground was regained with an outline agreement for further financial aid to Greece (though the outline fails to address the long term issue regarding the sheer scale of Greece’s debt burden). Moreover, the hawkish ECB continues to provide support from a yield perspective, signalling a second rate hike in July, while all other central banks sit firmly on their hands. The long term impact of rising interest rates could prove euro negative if it disrupts the recovery in the periphery economies, but this factor has certainly been supportive in the short term. The relative attractiveness of sterling and the dollar has been hit by softening growth/interest rate expectations and jitters over the size of the debt overhang facing these regions. With macro data pointing towards a further slowdown in UK and US economic activity, growth expectations have also been scaled back. Moody’s warned the UK that 16 banks could face a downgrade to its credit rating if a further slowdown in growth put the government’s fiscal austerity plans in jeopardy. Meanwhile, US policymakers continue to bicker over an extension to the Federal debt ceiling and a long term deficit adjustment plan. GBP/USD has been range bound between 1.60-1.65 for the past month and we continue to expect it to remain at these levels which also look to be close to fair value. JPY has appreciated against the USD and is approaching levels south of the 80 mark which triggered multilateral currency intervention in March.

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