In last week’s article, I wrote about the strong performance of the major international equity indices during the second quarter of the year following the sharp and abrupt decline experienced between mid-February and March 23.

Today’s article provides an analysis of currency movements over recent months. The value of a currency is always quoted in terms of how much it translates in another currency. Therefore, movements in exchange rates are a reflection of the strength or weakness in one currency relative to another. The two main currencies on the radar screens of local investors are undoubtedly the US dollar and the pound sterling. The value of the EUR against the USD and the GBP are therefore the two currencies most regularly monitored since movements in these two currencies impinge on the overall performance of investment portfolios.  Exchange rates are impacted by factors like the state of the economy,  government finances, political developments and interest rate and inflation expectations. Due to COVID-19, all major central banks announced  measures to stimulate economic activity which led to a high degree of volatility in exchange rates.

In early March, the Federal Reserve surprised financial markets with an emergency rate cut by slashing its benchmark interest rate by 50 basis points to between one and 1.25 per cent. A few days later, the Federal Reserve announced yet another cut by bringing interest rates close to zero and launched a $700 billion quantitative easing programme.

The European Central Bank launched a €750 billion pandemic emergency purchase programme (PEPP) on March 18 and in early June, announced an increase in the amount of asset purchases of €600 billion. The ECB’s PEPP was expanded to €1.35 trillion, and the central bank also indicated last month that it is extending the horizon for net purchases to at least the end of June 2021 and reinvesting the maturing principal payments from securities bought under the PEPP until at least the end of 2022.  The Bank of England (BOE) slashed interest rates twice in March to a record low of 0.1 per cent. Furthermore, on June 18, the BOE decided to continue with its existing £200 billion bond-buying programme targeting UK government bonds and non-financial investment-grade corporate bonds, while increasing the level of purchases of UK government bonds by an additional £100 billion to a total stock of asset purchases of £745 billion amid subdued inflation forecasts.

The EUR vs USD exchange rate exhibited a high degree of volatility in recent months with the US dollar strengthening towards the third week of March to almost $1.06. The volatility was considerable as only two weeks earlier, the euro stood at the $1.14 level before the US Senate approved a historic $2 trillion stimulus package on March 25. The US dollar weakened again to above the $1.11 level within a few days and hovered in a relatively tight range until end May.

The euro rallied once again since the end of May and maintained most gains particularly as the market digested the European Commission’s proposal for a €750 billion ‘Next Generation’ recovery fund. . A major factor that was negatively impacting the performance of the euro was the re-emergence of fears over a break-up of the single currency. However, the euro was also being supported by the larger-than-expected increase in the ECB’s asset purchase programme by €600 billion in early June. On its part, the US dollar was impacted by the heightened uncertainty on the US economic outlook due to the wider spread of the pandemic in the country which contrasted with the opening up of many economies across other parts of the world especially in Europe.

The EUR vs GBP was also particularly volatile in recent months. The pound sterling strengthened slightly to £0.83 towards the third week of February compared to a level of £0.845 at the start of the year. However, the euro rallied significantly also against the pound sterling in a short period of time to a level above £0.94 by mid-March before easing somewhat towards the £0.87 level by mid-April and moving back towards the £0.90 in recent weeks. The significant weakness in the pound sterling during March was attributed to the sharp drop in interest rates by the BOE, the sizeable bond-buying programme as well as the costly relief package by the government which led to a weakening outlook for the currency. Some analysts also opined that the UK’s exit from the EU from January 2020 made the currency more vulnerable.

The future trajectory of the pandemic and the extent of the economic recovery  are likely to be the determining factors impacting investor sentiment and currency movements. Moreover, those countries with higher levels of debt and whose governments pursue looser fiscal-policy measures to finance the economic recovery may need even larger balance-sheet expansions by their respective central banks. This additional liquidity would also likely weigh on the performance of currency markets.

The performance of the euro is linked to the fate of the proposed €750 billion Next Generation recovery fund. Its approval is especially important for some of the fiscally-challenged economies such as Italy, Spain and Greece. Until financial burden-sharing across the EU becomes a permanent concept, there will be periods of increased political risk leading to bouts of euro weakness. The immediate focus is therefore on the EU’s ‘special summit’ taking place tomorrow as the 27 nations forming the euro are set to discuss the bloc’s 2021-2027 budget and the coronavirus recovery plans.

From a UK perspective, a potential extension of the Brexit transition period would make the UK partially responsible for the upcoming additional payments by the wealthier EU countries to finance the recovery fund. In view of this, the UK government is even less likely to request an extension which many  believe could lead to further weakness of the pound sterling against the euro since it raises the possibility of a hard Brexit. The UK government’s finances are one of the least healthy among the G10 countries and mainly dependent on a significant amount of external financing. As at the end of September 2019, the UK government debt to GDP ratio was around 85 per cent. In view of the widening deficit which is expected to reach 13 per cent of GDP in 2020, the UK’s debt to GDP ratio  now has exceeded the 100 per cent level.

The difficulties related to Brexit negotiations are likely to continue to weaken investor sentiment towards the pound sterling. Many foreign exchange analysts are therefore indicating the pound sterling is increasingly susceptible to further downside risk with a particular bank recently reducing its forecast for sterling to £0.92 against the euro compared to an earlier forecast of £0.87. Meanwhile, another foreign currency analyst opined that without a deal between the EU and the UK governing their future relationship leading to a ‘hard Brexit’, the pound sterling could even drop to euro parity.

The future direction of the EUR/USD exchange rate depends on developments across the EU; a lack of an agreement to the recovery fund is likely to push the euro lower. Many believe  COVID-19 and the extent of the economic recovery are more likely to dominate movements in the US dollar rather than the election due to the comfortable lead of Joe Biden, expected to persist until election day. Other important developments taking place in the months ahead in various regions around the world are likely to lead to continued volatility across currency markets and other asset classes.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “Rizzo Farrugia”, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. Rizzo Farrugia, its directors, the author of this report, other employees or Rizzo Farrugia on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither Rizzo Farrugia, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.

© 2020 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

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